A raft of incoming regulations in Hong Kong seeks to shore up digital asset rules while potentially laying the groundwork for the territory to become the next “crypto-hub.”
In February, the Securities and Futures Commission (SFC), one of Hong Kong’s major financial regulators, published its proposed rules for digital asset trading platforms, including an unexpected change of heart allowing retail investors to access locally licensed exchanges.
This followed hot on the heels of the Hong Kong Monetary Authority (HKMA) laying out its plans for the comprehensive regulation of stablecoins, which would include regulating the governance, issuing, creation and destroying of ‘in-scope’ stablecoins, as well as the stabilization and reserve management arrangements of stablecoins and wallets.
Given Hong Kong’s previously-frosty attitude toward retail digital asset investment, combined with a history of skepticism from the mainland, the changes are notable. What do they entail, and what do they say about the future of digital asset regulation in the region?
Local exchanges on the cards
The SFC is responsible for regulating the securities and futures markets in Hong Kong, and since 2019, exchanges dealing in digital assets could get licensed by the SFC on a voluntary opt-in basis following a vetting process conducted by the SFC. The licensee must also adhere to several licensing conditions. Crucially, one of these conditions is that the exchange only offers services to professional investors, meaning retail investors had no access to Hong Kong’s vetted, licensed exchanges.
The SFC defines ‘professional investors’ as investors “generally regarded as more capable of protecting their interests,” such as intermediaries, authorized financial institutions, insurance companies, and recognized exchange companies. An individual may be considered a professional investor if they have a portfolio of at least HK$8 million.
Following the opening of a consultation period in November 2020, in 2022, Hong Kong passed amendments to its Anti-Money Laundering and Counter-Terrorist Financing (AMLCTF) law which would require all digital asset service providers offering services to Hong Kong residents to obtain a license from the SFC given that licensed entities can only offer services to professional investors, this effectively barred retail investors in Hong Kong from using Hong Kong-based exchanges to trade digital assets entirely.
However, under the latest revised regulatory proposals unveiled on February 20 this year, licensed entities would be able to offer digital asset services to retail investors “provided that the platforms comply with a range of robust investor protection measures.” Though the SFC is still seeking public input on the proposals, they remain set to enter into force on June 1.
This marks a significant development in the region. Previously, come June 1, all digital asset trading platforms would require a license, and retail investors would be barred access, which would have been a substantial clampdown on digital asset trading activities. Now, the license requirement remains in place, but exchanges will be able to serve retail investors, a noticeable softening of approach since the AMLCTF bill was announced in 2020.
The “robust investor protection measures” and guidelines for digital asset trading platforms that the SFC’s consultation paper outlined are based on the existing regulatory requirements of SFO-licensed platform operators and include the requirements to conduct knowledge assessments on investors before providing any services to them; taking reasonable steps to establish the true and full identity of each of its clients; conducting ongoing monitoring of each digital asset admitted for trading; and implementing appropriate AML/CFT policies, procedures and controls.
Until the amendment comes into force on June 1, unregulated digital asset trading platforms that chose not to opt into the 2019 regime (either because they don’t trade in anything that could qualify as a security or because they want to trade regulation-free) can operate and sell to professional and retail investors in Hong Kong—the government simply advises investor caution.
All these digital asset platforms will have to get a license or cease activities when the Bill comes into effect, but now the incentives for doing so seem more enticing than they did when only professional investors would be allowed access.
Stablecoins in the spotlight
Meanwhile, another of the territory’s top financial regulators, the HKMA, Hong Kong’s central banking institution, is attempting to get to grips with the assets themselves. The HKMA released the results of its own digital asset consultation on January 31, which focused on a potential regulatory regime governing stablecoins.
Under current Hong Kong law, digital currencies are not considered legal tender by the HKMA and so do not qualify as money. Thus they are not regulated by the organization or any other organization in Hong Kong.
To begin addressing this, on January 12, 2022, the HKMA issued a discussion paper on “crypto-assets and stablecoins” inviting feedback from stakeholders and outlining the regulator’s thoughts on a regulatory framework for “payment-related stablecoins.”
In its “Conclusion of Discussion Paper on Crypto-assets and Stablecoin,” published at the end of January, the HKMA outlined some of the feedback it received from 58 industry, public bodies, business, and professional organizations, and in response, the HKMA outlined how it intends to proceed.
Firstly, the regulator identified stablecoins as the primary concern, particularly those linked to fiat currency “given the higher and more imminent monetary and financial stability risks that they may pose.” The regulator proposed that new and existing stablecoin issuers will be subject to a mandatory licensing regime and need to prove “full backing and redemption at par,” meaning stablecoin reserves should always back the value in circulation, and the reserve assets should be of “high quality and high liquidity.”
As a result of the discussion process, the regulator came up with a “comprehensive regulatory framework” for in-scope stablecoins that covers the areas of governance, issuance, stabilization, and wallets. The framework would include key checks on ownership, anti-money laundering, and user protection procedure/policies, as well as imposing regular audits and disclosure requirements upon issuers.
The HKMA also stated that any entity conducting a “stablecoin-related activity,” in which the stablecoin concerned links its value to the Hong Kong dollar, would also need a relevant license and be subject to regulatory requirements, regardless of whether the activity is conducted in Hong Kong or marketed to the Hong Kong public—so foreign entities issuing or dealing in Hong Kong dollar-linked stablecoins will need a license from the HKMA to operate.
Interestingly, the framework expressly indicates that algorithmic or arbitrage-based stablecoins will not be fit for licensing.
Algorithmic stablecoins, rather than being backed 1:1 by a fiat currency, are backed by an on-chain algorithm that facilitates a change in supply and demand between the stablecoin and another cryptocurrency that props them up. Putting aside the controversies involved in stablecoins in general, the algorithmic model takes it to another level of uncertainty—the unpegging of TerraUSD (UST) in May 2022 being an often-cited example of the form’s untrustworthy nature.
It is also likely that businesses dealing in stablecoins, particularly Hong Kong Dollar linked coins, would fall under the HKMA’s money broker regulations, which require that institutions should be financially sound, with a minimum paid-up capital of HK$5 million ($636,935), and the identity of controllers should be known – both of these requirements might be difficult to comply with for smaller digital currency players and those who favor ‘anonymity.’
The conclusions of the regulator’s discussion paper are not set in stone and, at this stage, are just proposals that will take some time to be agreed on and brought into force, but they do serve as a strong indication of what the HKMA is planning on doing and how it views the future of regulation in the area, stablecoins in particular.
The moves signal that Hong Kong’s most prominent financial regulators are beginning to deal more actively with digital asset markets and could be seen as a reaction to the high-profile collapses and scandals in the digital asset space in 2022, significantly FTX in November and Terraform Labs in May – the latter of which prompted regulators worldwide to focus their attention on stablecoins.
The SFC’s Chief Executive Officer, Julia Leung, indicated as much when justifying the regulator’s plan: “In light of the recent turmoil and the collapse of some leading crypto trading platforms around the world, there is clear consensus among regulators globally for regulation in the virtual asset space to ensure investors are adequately protected, and key risks are effectively managed.”
However, Leung also suggested this move has been on the cards for a while, saying, “as has been our philosophy since 2018, our proposed requirements for virtual asset trading platforms include robust measures to protect investors, following the ‘same business, same risks, same rules’ principle.”
The differing interpretations of the motives behind the SFC and HKMA changes have created a mixed reaction, with some suggesting it signals a legitimizing and embracing of the digital asset space—which is what the “same business… same rules” mantra might suggests–while others have pointed to excessive requirements and the ‘our way or the highway’ approach potentially putting off businesses and damaging competition.
Under the SFC’s proposed plan, retail investors will be able to access licensed local exchanges, where previously, trading would have been restricted to professional or institutional investors. The reasoning is that investors are better off dealing with licensed venues rather than offshore and unregulated players—a regulate to protect or legalize to control approach.
One interpretation of the move is that it will attract capital, particularly from China, by making Hong Kong a possible home for digital asset exchanges to operate legally and allow retail customers in the region to access a legitimate local exchange.
Shortly after the SFC published its proposal, digital asset exchange Huobi, currently the 15th largest exchange by trading volume, announced that it aims to further expand its operations in Hong Kong, where it is already publicly listed and has offices. The company praised the incoming regulatory changes, saying “exciting news! Huobi is stoked about Hong Kong’s pro-crypto policies and we’re working hard to secure our crypto license there.” It added that its aim “is to be one of the first fully compliant exchanges in HK & collaborate with our Asia-Pacific users to drive digital asset growth!”
OKX are reportedly also now in the market for a Hong Kong license.
Despite Huobi’s assessment of the incoming changes as “pro-crypto,” not everyone has had the same positive read.
Optimistic interpretations of the regulation seem to focus on a perceived welcoming of the industry by regulators; however, the requirements for licenses and compliance are not straightforward, and the SFC has made it clear those that don’t meet the bar are out:
“Operators of virtual asset trading platforms which plan to apply for a license, including pre-existing platforms, should begin to review and revise their systems and controls to prepare for the new regime,” said the SFC. “Those which do not plan to apply for a license should start preparing for an orderly closure of their business in Hong Kong.”
This approach might scare as many businesses away as it attracts, bearing in mind that any listed entity will need a background check on issuers and developers; there needs to be checks on the supply, demand, and liquidity of the tokens listed; and technical aspects of the blockchain, marketing materials, utilities, and legal risks will also come under scrutiny.
In terms of the HKMA’s stablecoin update, as well as disappointing fans of algorithmic coins, the regulation comes with an extensive set of standards to meet. This is combined with additional corporate requirements, such as digital asset firms needing to have a locally incorporated entity in Hong Kong if they want to issue stablecoins, not just an office or branch—which is perhaps enough to put prospective companies off a lengthy and expensive process.
Another area of debate fueled by the flurry of incoming regulation revolves around whether it can be seen as an indication of a change in the prevailing winds coming from China and the significance, positive or negative, that this might have for Chinese companies and retail investors.
And the mainland
Hong Kong is still—technically—an independent territory, with its status as a ‘Special Administrative Region of China’ allowing it to have its own laws and governance, but as we’ve seen in recent protests regarding the controversial 2019 extradition bill, the invisible hand of Xi Jinping is often visible in Hong Kong policymaking and few, if any, major decisions get passed in the city without mainland approval.
If these latest regulatory changes indicate an ambition from Hong Kong’s administrators to become a digital asset hub, it would be safe to assume that China is—at least—not against the move, which contrasts with the mainland’s previous hardline stance.
In recent years China has been notoriously hostile to the digital asset space, banning crypto initial coin offerings (ICOs) in 2017 and last year ramping up the pressure, with authorities from the People’s Bank of China (PBoC) banning digital asset transactions. The industry has only been further rocked by scandal in the years since, with blow-ups such as the FTX crisis causing heightened scrutiny of the sector in many jurisdictions.
So why the—possible—change of heart?
Going back a few years, China was early to the “crypto” party. Investor enthusiasm dates back to 2011 when the first digital currency exchange, BTC China, opened in the country and peaked around 2013 when Baidu (NASDAQ: BAIDF), China’s search engine giant, began accepting Bitcoin as payment for website security services in 2013. A year later, Bitmain, one of the first digital currency mining equipment manufacturers and mining pool operators, also set up shop in the country.
However, the Chinese market collapse in 2015 put the brakes on this, discouraging some retail investors from trading again and resulting in greater scrutiny from authorities in Beijing amid fears that a digital asset crash could disrupt the financial and economic order in China.
Depending on how you view the recent regulatory announcements in Hong Kong, it could be argued that the HKMA’s and SFC’s incoming regulations are consistent with the temperature in Beijing, drawing all exchanges into a protective regulatory framework and increasing the requirements for digital asset players to legitimately operate in the city.
However, an alternate reading has it as embracing digital assets—and one endorsed by the mainland—which might suggest a softening of the country’s caution towards the industry.
One explanation for China’s possible unexpected endorsing of, or at least lack of opposition to, Hong Kong’s perceived crypto-hub ambitions may be about making it a sort of testing ground for the opening up and legitimizing of digital asset markets, watching how the city’s seven million population interact with digital assets without having to re-open the mainland to the potential risks.
“As long as one doesn’t violate the bottom line, to not threaten financial stability in China, Hong Kong is free to explore its own pursuit under ‘One Country, Two Systems,’” said Nick Chan, a National People’s Congress member and a lawyer who advises on cyber-security and digital assets, as reported by Bloomberg in February.
Chan’s view seems to support the idea that Hong Kong is being given a certain amount of leeway for experimentation as long as the financial stability of China is not at risk.
Huobi’s announcement that it is applying for a digital asset trading license in Hong Kong and launching a new trading venue there could be more evidence of China’s softening to the idea of crypto markets. The company’s Chairman and founder Leon Li is rumored to have the ear of China’s central bank, and while Binance earned the ire of mainland regulators by attempting to skirt the rules, Li towed the line by discouraging speculation, co-founding the country’s first state-backed blockchain platform and set up a Communist Party committee in-house – the first for any digital asset firm in China.
Add to this the report that officials from China’s Liaison Office have been recent “friendly” guests at digital asset gatherings in Hong Kong, and the territory’s regulatory picture begins to have more than a hint of China’s endorsement of it.
Mainland blessing or not, Hong Kong’s reputation as a financial hub could make it an attractive destination for global digital asset companies seeking to expand their presence in Asia, and a clearly defined regulatory environment could well encourage digital asset companies to set up shop in Hong Kong—particularly those with one eye on getting back into China’s vast retail investor market.
Watch: The Future of Digital Asset Exchanges & Investment
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