A number of measures show that Hong Kong is determined to foster a “vibrant ecosystem” for virtual assets and other related products.

Jill Wong, partner at law firm Reed Smith, writes about
how Hong Kong tackles regulating cryptocurrencies, a task
which involves judging how to balance innovation against
risk.

The editors are pleased to share these views and invites
readers’ responses. The usual editorial disclaimers apply. Email
tom.burroughes@wealthbriefing.com

Like many other jurisdictions, the initial response in Hong Kong
to the advent of bitcoin and other cryptocurrencies was to ask:
“what is this?” This has since evolved, although in the
initial stages of regulatory thinking virtual assets (VAs) were
regulated only to the extent that they fitted into existing laws
governing financial services. For example, VAs that resemble
traditional securities were treated as ‘securities’ or “futures
contracts’ under existing securities laws, and were subject
to the licensing, marketing and other requirements under Hong
Kong law.

However, as these laws were not formulated with VAs in mind,
there were VAs that did not fit neatly into traditional
definitions and so fell outside the regulatory net. The
securities regulator, the Hong Kong Securities and Futures
Commission (SFC), took steps to address this in the form of
public statements, warning the public that VAs, such as
cryptocurrencies, needed to be licensed. For instance, Initial
Coin Offerings could be seen as “collective investment
schemes,” and therefore required a licence under the
Securities and Futures Ordinance (SFO), whilst bitcoin futures
also required a licence under the SFO as “futures contracts.”

Matters accelerated in 2018 when the SFC expanded its regulatory
oversight to cover existing SFC licensees who were portfolio
managers and distributors of VA funds. This was a significant
step in bringing greater oversight and stability to the VA
ecosystem.

The SFC issued a position paper in 2019, outlining a new
framework for regulating centralised VA trading
platforms (VATPs). VATPs that provide trading services in both
non-security VAs and security VAs would fall within the
regulatory net of the SFC. However, a loophole existed: VATPs
that only dealt with non-security VAs remained unregulated.

This was soon dealt with. In June 2023, after extensive
consultation, Hong Kong enacted a comprehensive licensing regime
for VATPs. Under this regime, VATPs performing activities in
non-security VAs are required to obtain a VATP licence under the
Anti-Money Laundering and Counter-Terrorist Financing Ordinance
(AMLO).

The current position and outlook

Hong Kong has ambitions to be a VA hub. It is already moving in
the right direction, with the UN Trade & Development Report in
2023 ranking Hong Kong ninth in the world in terms of its
preparedness for frontier technologies. Hong Kong’s commitment to
innovation (while giving due protection to investors) and a
crypto-friendly legal framework have also positioned the
territory as a global leader in the VA space.

Hong Kong regulators continue to supplement the current framework
for VAs. This includes introducing licensing regimes for issuers
of fiat-referenced stablecoins and over-the-counter trading in
VAs. The regulators have already completed public consultations
on these regulatory proposals and plan to introduce the relevant
legislation soon.

Hong Kong also became the first jurisdiction in Asia to offer
retail investors the ability to trade spot bitcoin and Ether
ETFs, pioneering an in-kind redemption mechanism. This provided
investors with additional flexibility to buy and sell shares of
crypto tokens with a portfolio of securities, financial
derivative instruments or VAs instead of cash.

This is a pivotal move to integrate VAs into mainstream financial
products in Hong Kong. The inclusion of Ether also opens the door
for new ETFs tracking other major cryptocurrencies. This will
further diversify the offerings of exchange-traded products in
Hong Kong which now include a metaverse ETF, a blockchain
ETF and some VA futures ETFs.

Hong Kong is also investing heavily in fintech, a key driver for
the city’s competitive advantage. For example, the Hong Kong
government has commissioned the Hong Kong Monetary Authority
(HKMA) to subsidise training costs for eligible practitioners in
the finance sector under the Fintech Subsidy Scheme.

The latest 2023 “Fintech Promotion Roadmap” outlined five key
pillars for development, emphasising the adoption of fintech
solutions across Hong Kong’s banking industry, expanding the
fintech-savvy workforce, and enhancing data infrastructure.
At the same time, the HKMA’s exploration of a retail Central Bank
Digital Currency, the e-HKD, reflects the regulator’s commitment
to staying at the forefront of digital currency innovation.

Earlier this year, the HKMA launched a stablecoin
“sandbox.” This allows prospective issuers to conduct
experiments under relaxed regulatory settings and will facilitate
dialogue between the issuers and regulators. A high-profile
example is a fintech firm, founded by a former senior regulator,
actively working on a Hong Kong dollar-backed stablecoin,
partnering with prominent players in the digital payments and VA
sectors to explore the use of its stablecoin in retail and
cross-border payments.

Legal advantages?

Hong Kong’s legal system also provides a favourable environment
for the VA industry. Cryptocurrencies have been recognised by
Hong Kong courts as ‘property’ which can be the subject of a
trust in a liquidation context. The courts have also granted
freezing injunctions over cryptocurrencies as asset preservation
measures. These rulings provide welcome certainty for traders and
investors.

That said, while Hong Kong can be viewed as a crypto-friendly
jurisdiction, it is not an “easy” jurisdiction for regulatory
arbitrage. The current VATP licensing regime is stringent and
robust (some argue too stringent). The existing licensing regime
sets out detailed criteria for applicants’ financial resources,
management and governance structure, VA token admission
requirements, client assets custody, and anti-money laundering
and counter-terrorist financing policies.

The SFC has also reiterated that VATPs cannot serve mainland
Chinese residents. These exacting requirements and the lack of
access to mainland customers may have prompted several major
exchange players to withdraw their VATP licence applications.

However, a robust regulatory regime is arguably a necessary
foundation for sustainable growth. It gives credibility to
businesses that commit to compliance and boosts investor
confidence. This would explain the undiminished interest in Hong
Kong amongst the 17 would-be VATPs waiting to be licensed.

Is Hong Kong edging out the competition?

Traditional financial institutions interested in VA distribution
or fund management should be encouraged by recent moves by the
HKMA and SFC. In December 2023, the HKMA and SFC issued the third
joint circular on intermediaries dealing with VAs, expanding the
way for brokers, advisors and fund managers to provide VA-related
services.

There are additional guardrails for investor protection: most
VA-related products are likely to be considered as complex
products and, except in limited circumstances, distributors will
therefore need to comply with existing requirements for sales of
complex products. This includes a suitability assessment of the
VA-related product for the investors.

Only professional investors would have access to these
products. However, there are some options for retail
investors because they can trade VA-related products that are
traded on the Hong Kong Stock Exchange and some other specified
exchanges and the VA funds that are authorised by the SFC for
public offering. This should be a major boost to the VA markets
in Hong Kong.

In addition, the SFC has already greenlighted 25 funds allowing
them to have portfolios that invest more than 10 per cent in VAs.

Traditional banks and securities brokers can also offer VA
dealing services through partnerships with SFC-licensed VATPs.
Several securities brokers have already obtained the go-ahead
from the SFC and, whilst there are currently only two licensed
VATPs, there are likely to be more in future.

These measures demonstrate Hong Kong’s determination to foster a
vibrant ecosystem for VAs, innovative products, and those
that distribute, manage and invest in them. The global
marketplace is competitive, but Hong Kong has positioned itself
at the forefront of this global market and is well-placed to reap
the rewards in the coming years.

Disclaimer: This is for information only and is not
legal advice.