Interpreting Hong Kong's Cryptocurrency Consultation Document — The "Undervalued" Will and Ambition

Author | Special Researcher William, Wu Shuo

On February 20, 2023, the Hong Kong Securities and Futures Commission (SFC) released a "Consultation Paper" on cryptocurrency trading, marking an important step for the Hong Kong government in opening up the cryptocurrency trading sector. Initially, I did not have high expectations for the "Consultation Paper," mainly because there had been rumors about the policy benefit of "allowing retail investors to trade cryptocurrencies" prior to this, and based on the experiences of countries like Japan and South Korea, I believed that Hong Kong's cryptocurrency policy would largely be about "allowing 7 million Hong Kong residents to trade a few cryptocurrencies like BTC/ETH," without significant breakthroughs. It was not until a few days later that I read the entire "Consultation Paper" that I realized I had underestimated the government's will and ambition. To better interpret the "Consultation Paper," this article analyzes it from three aspects: framework blueprint, opportunities, and challenges.

1. Future Blueprint of Hong Kong's Cryptocurrency Market

According to the government's institutional arrangements, public consultation aims to help market participants understand the objectives of various regulatory proposals and allow the public to provide feedback, contributing to the establishment and maintenance of an effective regulatory system. From another perspective, the "Consultation Paper" can be seen as a draft for an actual legislative bill, which will not easily change in its broad direction. Therefore, we can glimpse Hong Kong's future "Web 3.0 development blueprint" from the "Consultation Paper." This "Consultation Paper" contains three important framework designs: dual licensing, access arrangements, and prohibitions.

1. Dual Licensing

According to Section IV of the "Consultation Paper" (see Preface 89-92), the Hong Kong government will implement a dual licensing system in the future, meaning that cryptocurrency trading platforms will need to hold both a license under the Securities and Futures Ordinance and a VASP license under the Anti-Money Laundering Ordinance.

For the license under the Securities and Futures Ordinance, according to the requirements of the SFC's 2019 "Position Paper," if a platform operator operates a virtual asset trading platform in Hong Kong and offers trading of at least one security token on its platform, it will fall under the jurisdiction of the SFC and must hold a Type 1 license (securities trading) and a Type 7 license (providing automated trading services), for example, the licensed platform OSL Digital Securities Limited actually holds Type 1 and Type 7 licenses. Additionally, if a cryptocurrency platform wants to provide some virtual asset investment advisory services to investors, a Type 4 license is also required.

To simplify the process, the "Consultation Paper" states that applicants applying for licenses under both the Securities and Futures Ordinance and the Anti-Money Laundering Ordinance only need to submit a comprehensive application form indicating that they are applying for both licenses simultaneously.

2. Access Arrangements

The access arrangements were an unexpected aspect for me. The original expectation was that the access arrangements would be "to allow Hong Kong residents to buy and sell mainstream cryptocurrencies," which contains two layers of meaning: first, an exclusion principle, only allowing residents to participate in trading, excluding users outside Hong Kong; second, the types of trades, only allowing users to trade a small number of mainstream cryptocurrencies, such as BTC and Ethereum, while other cryptocurrencies are excluded. However, the actual access arrangements in the "Consultation Paper" are more open.

First, regarding users, in addition to the well-known "allowing retail investors to participate in trading," the "Consultation Paper" does not set too many restrictions on the location of users.

Section 9.3 of the "Applicable Guidelines" states: "Platform operators should ensure compliance with applicable laws and regulations in the jurisdictions where they provide services and should develop and implement various measures," and lists measures including marketing restrictions, IP blocking, etc. This actually means that cryptocurrency trading platforms in Hong Kong can target global users, as long as they comply with the relevant jurisdiction's laws, so platforms can operate in countries and regions that are friendly to cryptocurrencies or have no relevant legal regulations, such as Japan, Singapore, and Turkey.

Secondly, on the asset side, the "Consultation Paper" distinguishes based on user types: for professional investors, the allowed trading product arrangement is "due diligence + prior notification," while for retail investors, the allowed trading product arrangement is "due diligence + qualified large virtual assets + written approval."

First is "due diligence." The "Consultation Paper" stipulates that "platform operators should conduct all reasonable due diligence on any virtual asset before including it for trading (whether or not offered to retail customers)" (specific review content can be found in Guideline 7.5). In addition, according to Guideline 7.8, platforms also need to conduct independent audits of the smart contracts of virtual assets. It is particularly important to note that if targeting retail investors, according to Guideline 7.9, it is required that "the virtual asset does not fall within the definition of 'securities' as defined in the Securities and Futures Ordinance."

Next is "prior notification." According to Guideline 16.4, virtual assets traded solely for professional investors only require prior notification to the SFC, without needing SFC approval. However, for assets sold to retail investors, Guideline 16.3 requires that "the platform must seek the SFC's written approval in advance regarding the relevant plan."

Finally, regarding "qualified large virtual assets," the "Consultation Paper" states, "Before being included for trading by retail users, it should have been included in at least two indices provided by at least two index providers," and stipulates that "the two index providers should be independent and unrelated to each other, and at least one index should be proposed by an index provider with experience in publishing traditional securities market indices."

From the above, it can be seen that for professional investors, the regulations on asset types are more lenient; whether or not the cryptocurrency falls within the category of "securities," it can be traded, only requiring notification to the SFC; but for retail investors, the requirement is "qualified large virtual assets," which actually provides a market-oriented institutional guarantee for including cryptocurrencies other than BTC and ETH in the trading product series for retail investors. From my perspective, cryptocurrencies ranked in the top five or even top ten by market capitalization are likely to be included.

However, the "Consultation Paper" stipulates that for retail investors, the SFC has the review authority, and "whether the cryptocurrency falls under the definition of securities" is still a matter of debate in the industry, with the criteria effectively determined by the Hong Kong SFC. This is a "double-edged sword," as it protects the rights of retail investors but also restricts market trading freedom. A typical case is Japan; although Japan has long legalized cryptocurrency trading, trading of crypto assets requires approval from the Financial Services Agency of Japan, and currently, only about eight cryptocurrencies are allowed for trading, which is a major reason why the Japanese market has not developed.

Overall, in terms of access arrangements, the Hong Kong government's openness has exceeded my expectations, but from some detailed designs, we can also see that the Hong Kong SFC faces certain challenges in balancing market prosperity and investor protection.

3. Prohibitions

The "Consultation Paper" clearly states:

• Platform operators should not publish any advertisements related to specific virtual assets (see Guideline 9.18);

• Platform operators should not engage in any sales, trading, or buying activities related to virtual asset futures contracts or related derivatives (see Guideline 7.23);

• Unless it is back-to-back trading outside the platform established by the platform operator and permitted by the SFC in rare individual cases, platform operators should not engage in proprietary trading (see Guideline 13.2).

Currently, the vast majority of cryptocurrency exchanges have derivatives and proprietary trading businesses, with derivatives accounting for a large portion of their revenue. Therefore, it is foreseeable that most cryptocurrency trading platforms will find it difficult to relocate entirely to Hong Kong; one feasible approach is to establish branches or independent subsidiaries in Hong Kong.

It is worth noting that the Hong Kong SFC has conducted public research on derivatives business during this consultation, and specific policies and regulations regarding derivatives are expected to be introduced in the future.

2. Future Opportunities in Hong Kong's Cryptocurrency Market

After the release of the "Consultation Paper," many Web 3.0 practitioners view it as a new development opportunity for cryptocurrency trading platforms. In fact, cryptocurrency trading platforms are not the biggest opportunity—besides the fact that competition in the trading sector is already fierce, the "Consultation Paper" has not touched on some details that significantly impact trading platforms (see the next chapter for specifics). From an overall framework perspective, I believe opportunities mainly concentrate in the following areas:

(1) KYC/AML Services—Creating an Asian Version of ChainAnalysis

The "Consultation Paper" lists "Know Your Customer" and "Anti-Money Laundering/Terrorist Financing" as one of the key regulations, with Appendices B and C providing clear guidelines on KYC/AML. In the foreseeable future, KYC/AML services will become a necessity for compliant trading platforms in Hong Kong, leading to the emergence of Asian companies comparable to ChainAnalysis.

(2) Cryptocurrency Indices—Market Strategic Business

One of the biggest highlights of the "Consultation Paper" is that "inclusion in cryptocurrency indices" has become a necessary condition for "whether an asset can be offered to retail investors." On one hand, whether an asset has "high liquidity" is left to market judgment, reducing the space for rent-seeking and improving market efficiency; on the other hand, assets included in relevant indices will attract more funds, enhancing their liquidity. In the future, cryptocurrency indices will not only have the "referee power" regarding whether they can be sold to retail customers but will also give rise to a large number of asset management products, making it a strategic business area for development.

(3) Supporting Services for Exchanges—Security, Monitoring, Assessment, Insurance

Industry insiders have described Asian cryptocurrency trading platforms as "orphaned in Asia," always searching for a "promised land" to settle down. After the introduction of numerous favorable policies in Hong Kong, although many details remain unclear, it does not prevent major cryptocurrency trading platforms from queuing up to "set up shop" in Hong Kong. The "Consultation Paper" has made arrangements for cybersecurity, monitoring systems, regulatory assessments, external insurance, etc., which will create huge market demand for related supporting services for exchanges, as evidenced by various trading platforms hiring Responsible Officers (ROs) at high salaries locally in Hong Kong. However, it should be noted that this field is overly segmented; although there are opportunities, it is difficult to produce unicorn giants.

3. Future Challenges in Hong Kong's Cryptocurrency Market

Although the release of the "Consultation Paper" has instilled confidence, it has not provided detailed explanations on some important technical details, bringing a degree of uncertainty to future developments, mainly reflected in the following aspects:

1. Bank Accounts

In 2017, when most countries or regions had not yet taken substantial regulatory steps regarding cryptocurrencies, Japan was the first to introduce relevant laws, legalizing cryptocurrency trading and becoming the world's first cryptocurrency-friendly country. However, five years later, Japan has not become an international center for Web 3.0, one important reason being that licensed Japanese exchanges only allow customers to purchase cryptocurrencies using real-name Japanese bank cards, effectively isolating foreign customers.

According to market research, most commercial banks in Hong Kong currently do not support the opening of bank accounts for cryptocurrency-related businesses; furthermore, 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 regulation of commercial banks and requires cooperation between the Hong Kong SFC and the Monetary Authority. To some extent, the issue of bank accounts will be one of the important factors determining whether Hong Kong will become an international center for Web 3.0 in the future.

2. Trading Pair Issues

Another reason Japan has not become a cryptocurrency trading center is that licensed Japanese exchanges only allow trading between yen and digital currencies, meaning they only have fiat trading pairs, and the total number of such trading pairs is limited, severely restricting users' investment freedom. In reality, cryptocurrency trading pairs (such as BTC, ETH, USDT, etc.) have gradually become the market mainstream. More importantly, cryptocurrency trading pairs can reduce the use of bank accounts, allowing users to deposit and withdraw coins directly on the platform for trading, which is more closely linked to the ecosystems of DeFi, GameFi, and other industries. Of course, this will put some pressure on the KYC/AML of trading platforms. However, if Hong Kong wants to become a Web 3.0 center, it must at least open cryptocurrency trading pairs, including the option of using Hong Kong dollar stablecoins as the pricing currency to gain a voice for the Hong Kong dollar in the industry. Currently, the "Consultation Paper" has not provided clear stipulations on this detail.

3. Financial Stability Issues

According to Guideline 6.3, "platform operators must maintain liquid assets not less than the prescribed liquid funds at all times," and detailed explanations of the calculation basis and warning lines for liquid funds are provided (6.3, 6.8). However, the reality is that most cryptocurrency trading platforms do not hold liquid assets in the traditional sense but hold large amounts of various types of cryptocurrency assets, which have significant differences in liquidity and risk. For example, the financial statements that emerged after the bankruptcy of FTX show that FTX primarily held various cryptocurrencies, and the rapid depletion of liquidity of cryptocurrencies under certain conditions was one of the main reasons for FTX's bankruptcy. Therefore, regarding financial stability, the SFC may need to make special provisions for liquidity regulation.

4. Conclusion

Due to the impact of the pandemic and geopolitical factors, Hong Kong's status as an international financial center has been challenged in recent years. The release of this "Consultation Paper" serves as a strong declaration from the Hong Kong government to consolidate its position as an international financial center, and the opportunities contained within can be likened to the rise of the modern foreign exchange market after the collapse of the Bretton Woods system in the 1970s. This is not only worthy of attention from Web 3.0 practitioners but also deserves the attention of all professionals in the financial industry.