Author：William, Special Researcher

Editor： WuBlockchain

On February 20, 2023, the Hong Kong SFC issued the “Consultation Paper” on cryptocurrency transactions, marking an important step taken by the Hong Kong government in liberalizing the field of cryptocurrency transactions. At first, I did not have high expectations for the “Consultation Paper”. The main reason is that the policy of “allowing retail investors to trade cryptocurrencies” has been rumored before, and the second is based on the experience of Japan, South Korea and other countries. It is believed that Hong Kong’s cryptocurrency policy is basically “allowing 7 million Hong Kong residents to trade a few currencies such as BTC/ETH”, and there has not been much breakthrough. It was not until a few days later that I read the entire “Consultation Paper” that I realized that I had underestimated the will and ambitions of the Hong Kong government. In order to better unveil the “Consultation Paper”, this article will analyze from three aspects: the framework blueprint, opportunities and challenges.

Future blueprint of Hong Kong cryptocurrency market

According to the institutional arrangements of the Hong Kong government, the purpose of public consultation is to help market participants understand the goals of various regulatory proposals, and to allow the public to express their opinions and contribute to the establishment and maintenance of an effective regulatory system. From another perspective, the “Consultation Paper” can be regarded as a draft of the actual implementation of the bill that will not be easily changed in the general direction. Therefore, we can get a glimpse of Hong Kong’s future “Web 3.0 Development Blueprint” from the “Consultation Paper”, which contains three important framework system designs: dual licenses, access arrangements and prohibited matters.

1. Dual license

According to the provisions of Part IV of the “Consultation Paper” (see Preamble 89–92), the Hong Kong government will implement a dual license system in the future, that is, the cryptocurrency trading platform needs to hold both the license under the “Securities and Futures Ordinance” and the VASP license under the “Anti-Money Laundering Ordinance” .

For licenses under the Securities and Futures Ordinance, according to the requirements of the “Position Statement” issued by the Hong Kong SFC in 2019, a platform operator that operates a virtual asset trading platform in Hong Kong and offers trading of at least one security token on its platform, which will be under the jurisdiction of the Hong Kong SFC and must hold №1 license (securities trading) and №7 license (providing automated trading services). For example, licensed platform OSL Digital Securities Limited actually holds №1 and №7 licenses. In addition, if the cryptocurrency platform is to provide investors with some virtual asset investment consulting services, then the №4 license is also necessary.

In order to simplify the procedure, the “Consultation Paper” stipulates that applicants who apply for licenses under the Securities and Futures Ordinance and the Anti-Money Laundering Ordinance at the same time only need to submit a comprehensive application form and indicate that they are applying for two licenses at the same time.

2. Access arrangements

In terms of access arrangements, which quite surprises me this time. According to the original expectation, the access arrangement is expected to be “allowing Hong Kong residents to buy and sell mainstream cryptocurrencies”. That contains two meanings: one is the principle of exclusion, only residents are allowed to participate in the transaction this time, and users outside Hong Kong are excluded; another is the type of transaction, which only allows users to trade a small number of mainstream cryptocurrencies, such as BTC and Ethereum, and other cryptocurrencies are excluded. However, the design of access arrangements in the Consultation Paper is more open.

First of all, in terms of users, apart from the well-known “allowing retail investors to participate in transactions”, the “Consultation Paper” does not set too many restrictions on the location of users.

Part 9.3 of “IX. Transactions with Customers” of the “Applicable Guidelines” stipulates: “Platform operators should ensure that they comply with the applicable laws and regulations in the jurisdictions where they provide services, and should formulate and implement various measures”, And cited measures including marketing restrictions, IP blocking and so on. This actually means that the cryptocurrency trading platform in Hong Kong can be open to global users as long as it abides by the laws of relevant jurisdictions. Then in principle, the platforms can be developed among countries and regions that are friendly to cryptocurrency or have no relevant laws and regulations, such as Japan, Singapore and Turkey.

Secondly, on the asset side, the “Consultation Paper” differentiates according to user types: for professional investors, the allowed trading product arrangement is “Due diligence + Advance notice”, and for retail investors, the allowed trading product arrangement is “ Due Diligence + Eligible Large Virtual Assets + Written Approval”.

The first is “Due Diligence”. The Consultation Paper stipulates that “a platform operator should conduct all reasonable due diligence on any virtual asset before including it for trading (whether to retail customers or not)” (See “Guidelines” 7.5 for specific review content). In addition, according to the “Guidelines” 7.8, the platform also needs to conduct an independent audit of the smart contract of the virtual asset. In particular, if it is aimed at retail investors, according to “Guidelines” 7.9 , it is required that “virtual assets do not fall within the scope of the definition of ‘securities’ under the Securities and Futures Ordinance”.

The second is “pre-notification”. According to “Guidelines” 16.4, virtual assets that are only for professional investors to buy and sell only need to notify the SFC in advance, without the approval of the SFC. However, for assets sold to retail investors, “Guidelines” 16.3requires that “the platform seeks the written approval of the CSRC in advance for the relevant plan”.

Finally, “qualified large-scale virtual assets”, the “consultation paper” pointed out, “Should have been included in at least two or accepted indexes launched by at least two index providers before being included for retail users to buy and sell. “, and stipulates that “the two index providers shall be unrelated and independent of each other, and at least one index shall be proposed by an index provider who has experience in publishing indices for the traditional securities market”.

It can be seen from the above that for professional investors, the regulations on asset types are more relaxed, regardless of whether cryptocurrencies belong to the category of “securities”, they can be traded, and they only need to report to the SFC. But in terms of retail investors, the requirement is “qualified large-scale virtual assets”, which actually provides a market-oriented institutional guarantee for cryptocurrencies other than BTC and ETH to be included in the retail investor trading product series. From my point of view, the top five or even top ten cryptocurrencies by market capitalization are all likely to be selected.

However, the “Consultation Paper” stipulates that for retail investors, the SFC has the right to review. “Whether cryptocurrencies are securities” is still debated in the industry, and the scale is actually determined by the Hong Kong SFC. This is a “double-edged sword”. The advantage is that it protects the rights and interests of retail investors, and the disadvantage is that it restricts the freedom of market transactions. One of the typical cases is Japan. Although Japan has already legalized cryptocurrency transactions, the transaction of encrypted assets needs to be audited by the Japanese Financial Services Agency. Currently, there are about 8 kinds of cryptocurrencies that are allowed to be traded in Japan, which is also the main reason why the Japanese market failed to develop.

Generally speaking, in terms of access arrangements, the Hong Kong government’s openness has exceeded my expectations, but we can also see from some detailed designs that, the Hong Kong SFC is facing certain challenges on how to balance market prosperity and investor protection.

3. Prohibition

The Consultation Paper clearly stipulates that

Platform operators should not publish any advertisements related to specific virtual assets (see “Guidelines” 9.18);

Platform operators should not conduct any sales, trading or buying and selling of virtual asset futures contracts or related derivatives (see “Guidelines” 7.23);

Unless it is an off-platform back-to-back transaction entered into by the platform operator and under limited circumstances permitted by the SFC on a case-by-case basis, the platform operator should not engage in proprietary trading (see “Guidelines” 13.2).

At present, the vast majority of encrypted exchanges have derivatives business and self-operated business, of which derivatives business accounts for the majority of revenue. Therefore, it is foreseeable that it is difficult for most cryptocurrency trading platforms to relocate to Hong Kong as a whole. One of the feasible waysis to set up a sub-station or an independent subsidiary in Hong Kong.

It should be noted that the Hong Kong SFC has conducted research on the derivatives business to the public during this consultation, and it is expected that specific policies and regulations related to derivatives will be issued in the future.

Future Opportunities in Hong Kong’s Cryptocurrency Market

After the release of the Consultation Paper, many Web 3.0 practitioners regard it as a new development opportunity for cryptocurrency trading platforms. In fact, the cryptocurrency trading platform is not the biggest opportunity — except that the competition in the trading track is already very fierce, the “Consultation Paper” has not yet touched on some details that have a significant impact on the trading platform (see the next chapter for details). From the perspective of the overall framework, the author believes that opportunities are mainly concentrated in the following areas:

(1) KYC/AML service — — Birth of the Asian version of ChainAnalysis

This “Consultation Paper” lists “know your customer” and “anti-money laundering/terrorist financing” as one of the key regulations, and Appendix B and Appendix C are clear guidelines on KYC/AML. In the foreseeable future, KYC/AML services will become a rigid demand for compliance trading platforms in Hong Kong, and there will be Asian companies comparable to ChainAnalysis.

(2) Cryptocurrency Index — — Market Strategy Business

One of the biggest highlights of this “Consultation Paper” is that “inclusion in the cryptocurrency index” becomes a necessary condition for “whether the asset can be used for retail investors”. On the one hand, whether an asset has “high liquidity” is left to the market to judge, which reduces the space for rent-seeking rights and improves market efficiency; on the other hand, after the asset is included in the relevant index, more funds will flow in to enhance its liquidity. In the future, in addition to the “judgment power” of whether the cryptocurrency index can be sold to retail customers, a large number of asset management products will be derived from it, so it can be deployed as a strategic business.

(3) Exchange supporting services — — security, monitoring, evaluation, insurance

Some people in the industry have described Asian cryptocurrency trading platforms as “orphans of Asia” who have been looking for a place where they can “take root”. After Hong Kong introduced many favorable policies, although many details are still unclear, it does not prevent major cryptocurrency trading platforms from queuing up to “settle down” in Hong Kong. The “Consultation Paper” has made arrangements for network security, monitoring system, regulatory assessment, external insurance, etc., which will bring huge market demand for exchange-related supporting services. From the current major trading platforms to hire ROs with high salaries in Hong Kong (Responsible Officer) can be seen. However, it should be noted that the field is too segmented, and although there are opportunities, it is difficult for unicorn giants to emerge.

Although the publication of the “Consultation Paper” gave confidence, the “Consultation Paper” did not elaborate on some important technical details, which brought a little uncertainty to future development, mainly reflected in the following aspects:

Future challenges in the Hong Kong cryptocurrency market

1. Bank account

In 2017, when most countries or regions in the world had not yet taken a step in substantive regulation of cryptocurrencies, Japan took the lead in promulgating relevant laws to legalize cryptocurrency transactions, becoming the world’s first cryptocurrency-friendly country. However, after nearly five years, Japan has not become an international center for Web3.0. One of the important reasons is that licensed Japanese exchanges only allow customers to purchase cryptocurrencies with real-name Japanese bank cards. This threshold basically isolates foreign customers.

According to market research, most commercial banks in Hong Kong currently do not support the opening of bank accounts for cryptocurrency businesses; secondly, whether overseas bank accounts can be connected to trading platforms in Hong Kong has not been clearly stipulated in the Consultation Paper. It should be noted that this issue involves the supervision of commercial banks and requires the cooperation and cooperation of the Hong Kong SFC and the Hong Kong Monetary Authority. To a certain extent, the bank account issue will determine whether Hong Kong will become one of the important factors of the Web3.0 international center in the future.

2. Trading pair issues

Judging from the actual situation, the current currency trading pairs (such as BTC, ETH, USDT and other trading pairs) have gradually become the mainstream of the market. More importantly, currency-to-currency trading pairs can reduce the use of bank accounts, and users can directly deposit and withdraw coins on the platform for transactions, which is more closely connected with DeFi, GameFi and other industry ecology. Of course, this will put some pressure on the KYC/AML of the trading platform. However, if Hong Kong wants to become a Web3.0 center, it must at least open currency trading pairs, including the choice of denominated currency, and Hong Kong dollar stable currency can be used to strive for the right to speak in the industry. This detail has not yet been clearly stipulated in the Consultation Paper.

3. Financial soundness issues

According to the provisions of “Guidelines” 6.3, “the platform operator must maintain the liquid capital not less than the platform operator’s specified liquid capital at all times”, and the calculation basis and warning line of the liquid capital are given in detail (6.3, 6.8). However, the reality is that most cryptocurrency trading platforms do not hold liquid assets in the traditional sense, but hold a large number of different types of cryptocurrency assets, and the liquidity and risks of these assets are very different. For example, from the financial statements released after FTX’s bankruptcy, it can be seen that FTX mainly holds various cryptocurrencies, and the rapid drying up of cryptocurrencies’ liquidity under certain conditions is one of the main reasons for FTX’s bankruptcy. Therefore, in terms of financial soundness, the SFC may need to make special regulations on liquidity supervision.

At the end

Due to the impact of the epidemic and geopolitics, Hong Kong’s status as an international financial center has been challenged in the past few years, and the release of this “ is nothing less than a strong declaration by the Hong Kong government to consolidate its status as an international financial center. It can be compared to the modern foreign exchange market that emerged after the disintegration of the Bretton Woods system in the 1970s. It deserves not only the attention of Web3.0 practitioners, but also the attention of all practitioners in the financial industry.

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