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.