Regulation
Why Hong Kong cryptocurrency custodians and exchanges are fighting over customer assets – DL News
- Kal Chan, CEO of Zodia Custody, says new rules are needed to separate custody services from exchanges.
- OSL executive director Gary Tiu countered that existing rules protect investors.
- The debate simmers as Hong Kong welcomes Bitcoin and Ether ETFs.
Cryptocurrency businesses typically bristle at regulation. But in Hong Kong, one group has repeatedly demanded it: cryptocurrency custodian companies.
“We want to be regulated,” said Kal Chan, CEO of Zodia’s Hong Kong unit. DL News.
Zodia Custody, which is backed by British banking giant Standard Chartered, is eager to work with regulators to develop specific regulations for cryptocurrency custodians, companies that look after clients’ digital assets.
And in particular, they want authorities to stop requiring cryptocurrency exchanges to manage exchange users’ assets through an “associated entity” and not be able to use third-party custodians.
The dangers of mixing
The problem, Zodia said, is that having exchanges deal with clients’ assets as well as their own funds creates the impression that they can be commingled.
This is taboo in capital markets, as exchanges should be neutral facilitators of buying and selling, not exploiting customer deposits for their own purposes.
“It’s not really a good practice to have exchanges that operate exchanges that also hold clients’ assets,” Chan said.
Indeed, asset misappropriation was one of the main reasons why FTX, the world’s second largest cryptocurrency exchange, failed in 2022.
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The practice was also behind the collapse of Celsius, the cryptocurrency lender that went bankrupt the same year, according to lawsuits filed by U.S. officials. (Chan was Head of APAC Institutional Business at Celsius from November 2020 to September 2022.)
Of course, custodians will also benefit from a change in the rules, as it will bring them more customers.
“You need to be confident that wherever you store crypto assets, they will be safe.”
—Kal Chan, Zodia’s Guard
Specifically, custodians will be able to attract more institutional investors who are reluctant to hold their assets on platforms where transparency and controls are inadequate.
“Ultimately, if you hold crypto assets, you need a place to store them,” Chan said. DL News.
“You need to have confidence that wherever you store it, it will be secure and that you are working with a reputable player.”
“Hong Kong’s regulatory framework creates a standard of conduct where one did not previously exist.”
—Gary Tiu, OSL
Of course, not everyone agrees with Chan’s point of view.
Gary Tiu, Executive Director and Head of Regulatory Affairs at OSL, a Hong Kong-based licensed exchange, said: DL News it is not the regulations that create a duopoly, but the sign of a fully maturing market.
“Hong Kong’s regulatory framework creates a standard of conduct where no such standard existed before,” Tiu said.
If operators don’t meet these standards, it’s not the fault of regulators who are too harsh, he said. Additionally, regulations to protect assets held on exchanges already exist.
“Every year we have an independent audit of our financial statements, our compliance and our technology,” he said.
Regardless, Chan hopes there will be a consultation period later this year for depositories, a sign that regulators are seriously considering changes.
One of the advantages of custodial companies in Hong Kong is the difficulty in controlling the many exchanges that offer unregulated crypto trading in the city.
For more than a year, Hong Kong’s financial regulators have been pushing hard to get exchanges to apply for licenses.
Two platforms are registered: OSL and Hashkey. And a dozen others applied.
A duopoly?
Both OSL and Hashkey operate as exchanges and manage their clients’ funds.
Chan said the two constitute a duopoly when it comes to child care. For example, both companies retain the assets of all issuers of the recently released spot price. Bitcoin and Ether ETF as sub-custodians.
The six ETFs all share the same primary custodian – BOCI-Prudential, a subsidiary of the Bank of China.
This is something Zodia cannot do due to local regulations.
“We obviously have an ongoing dialogue with regulators about what best practices should be,” Chan said.
Tiu countered that current practices work very well for investors.
“These are actually very essential protections that market participants should expect from operators,” Tiu added. OSL is also subject to self-reporting obligations if it becomes aware of breaches in the segregation of client assets.
“We have a regulatory framework that ensures an adequate operating environment,” Tiu said.
Tiu added that while there is not yet a separate custodial licensing regime for crypto, there is no standalone custodial regime for traditional finance either.
“I think right now, at this stage of the market, the current regime is still the right one. As the technology and market continue to mature, we will evolve,” he added.
2,700 family offices
Until the regulatory framework changes, Chan said Zodia’s small Hong Kong-based team works primarily with family offices.
Hong Kong has about 2,700 single-family offices, according to a Deloitte study commissioned by the local government. Each office manages at least US$1.3 million, and 885 manage more than US$13 million.
The government has set a target of attracting 200 additional large family offices to the city by 2025 and has introduced a host of incentives, including tax breaks.
Growing interest
Family offices in Asia have already reported growing interest from their clients in investing in crypto assets to diversify their portfolios.
“We either help them enter the space and serve as a custodian or store some of the assets they already have,” he explained.
“A lot of these prospects, companies and institutions that are trying to get into this space, are comfortable enough to talk to us. They actually want to talk to us because we speak the same language,” he said.
“I think Hong Kong is becoming an increasingly important hub for the digital assets world, mainly in the more institutional side of things.”
Healthy development
Tiu added that he believed it would nevertheless be a “healthy development” to see more facets of the sector regulated in Hong Kong.
“I don’t think it’s as simple as introducing regulations and a lot of custodians will come into play,” he said, adding that the market may not be willing to pay for expensive infrastructure.
“If you try to introduce even more elements into the equation, we also have to ask the question of whether the business environment will support so many players,” he said.
Callan Quinn is DL News’ Hong correspondent. Do you have a story about crypto in Asia? Contact us at callan@dlnews.com.