OKLink Research Institute: The Security Path Behind Hong Kong's Virtual Asset ETFs

Produced by｜OKLink Research Institute

Author｜Jason Jiang

As the U.S. SEC undergoes a 180-degree shift in its stance on Ethereum spot ETFs, the UK's financial regulatory body also approved the first batch of cryptocurrency exchange-traded products on the 22nd, taking steps to catch up with other virtual asset centers. Meanwhile, across the ocean, the Hong Kong market, which was the first to launch Bitcoin and Ethereum ETFs, is now recovering after a period of lackluster performance: According to SosoValue, as of May 21, the total scale of Hong Kong's virtual asset spot ETFs has exceeded $310 million, experiencing stable growth over five consecutive trading days.

Setting aside the industry benefits of accelerating the integration of traditional finance and virtual assets, the most tangible advantage for ordinary investors participating in virtual asset spot ETFs is the enhanced security. This security is primarily reflected in more reliable custody measures and compensation arrangements. Given the unique nature of virtual assets, in addition to the main custodian, Hong Kong's virtual asset spot ETFs now employ professional sub-custodians responsible for the custody of virtual assets, thereby improving fund asset management efficiency while diversifying custody risks. Sub-custodians must ensure that the virtual assets corresponding to the spot ETFs are separated from their own assets and those held for other clients, and they need to store most virtual assets in cold wallets, keeping only a small amount temporarily in hot wallets to meet subscription and redemption needs.

This is largely consistent with the SFC's custody requirements for VATP. Regarding virtual asset custody, OKLink has previously made additional recommendations to Hong Kong regulatory authorities. For example: the hardware used for cold wallet custody of virtual assets should be stored in a decentralized manner, and private keys should only be used for a single transaction, after which they should be discarded and updated; hot wallets can utilize cryptographic techniques such as MPC key sharding to store private keys. Some of these recommendations have already been applied and practiced in Hong Kong's virtual asset ecosystem.

In addition, sub-custodians should establish appropriate compensation arrangements through third-party insurance or other permitted means, ensuring coverage for potential losses in cold wallets that are at least up to the necessary percentage specified by applicable licensing requirements related to virtual asset sub-custodians, as well as 100% potential losses for virtual assets stored in hot wallets or other means, thereby ensuring that even if assets are damaged, investors can receive tangible protection.

In terms of investment strategy, according to the Hong Kong Securities and Futures Commission regulations, virtual asset spot ETFs are not allowed to invest in any financial derivatives, engage in securities lending, sales, repurchase transactions, or reverse repurchase transactions, nor can they employ any form of leverage regarding virtual assets; at the same time, issuers must develop liquidity management policies based on market conditions, identifying, supervising, and managing risks through various liquidity risk management tools to ensure that investors' redemption requests can be met in a timely manner.

Supporting physical subscriptions and redemptions is the main difference between Hong Kong and the U.S. in the field of virtual asset spot ETFs. Although physical subscriptions and redemptions respond more quickly in terms of liquidity and price direction and can attract broader market attention and investment groups for spot ETFs, the involvement of on-chain processes and additional participants increases the corresponding risks. To address these risks, Hong Kong's virtual asset ETFs have also made corresponding institutional arrangements. For instance, during the product subscription period of IOP, to cope with price fluctuations of the underlying assets, virtual asset spot ETFs collect excess safety buffer funds to ensure the smooth operation of fund share creation. This type of excess collateral practice is not uncommon in the virtual asset industry; for example, the asset-collateralized stablecoin DAI ensures the sufficiency of underlying assets through an over-collateralization model, thereby achieving relative pegging to the U.S. dollar. However, apart from the IOP phase, investors do not need to provide high amounts of safety buffer funds when physically subscribing for ETF shares, as the physical subscription process is more convenient and does not involve cash-based virtual asset purchases, with related price fluctuations to be borne by investors after the subscription is completed.

To address the money laundering risks associated with physical subscriptions and redemptions, Hong Kong also requires that institutions participating in the operation of virtual asset ETFs, including fund companies, custodians, virtual asset trading platforms, and participating brokers, must all be licensed and recognized institutions; at the same time, these institutions must conduct strict KYC/AML review processes before clients can deposit or withdraw assets, reducing the risk of illegal activities. At the broker level, Victory Securities currently conducts two KYC checks on clients before trading, and if a client's account shows large virtual assets that do not comply with KYC standards, a further due diligence review is conducted; at the virtual asset trading platform level, ownership verification of client wallets is conducted based on KYC to ensure clients' ownership and control of the assets in their wallets, while also checking the on-chain transaction history of the past several dozen transactions of the wallet through KYT (Know Your Transaction), screening wallet addresses, and allowing virtual asset deposits and withdrawals only after passing whitelist verification, thereby reducing the risk of black and gray addresses participating in ETF trading. In fact, as the adoption of virtual assets increases, compliance analysis tools based on on-chain data, such as KYT, have become essential for all parties in the virtual asset market. OKLink Research Institute has previously emphasized the importance and practicality of KYT technology to relevant institutions in public consultations on Hong Kong VATP, fiat-backed stablecoins, and VAOTC.

As a mature financial product and a key product for the mainstreaming of virtual assets, spot ETFs not only accelerate the integration of traditional finance and virtual assets but also provide a compliant channel for a broader group of investors. Although they cannot change the high volatility of Bitcoin and Ethereum, security remains a core issue for ETFs. The aforementioned arrangements of Hong Kong's virtual asset spot ETFs in investment strategy, asset custody, and KYC/AML demonstrate a commitment to investor protection and anti-money laundering issues. These measures will enhance investor trust and confidence in ETF products, attract more funds into the market, and promote the prosperity of Hong Kong's virtual assets and Web3 ecosystem.

About OKLink Research Institute

OKLink Research Institute is a strategic research institution under OKLink Group, dedicated to helping global businesses, public, and social sectors gain deeper insights into the evolution of fintech and the blockchain economy, providing in-depth analysis and professional content covering topics such as technological applications and innovations, the evolution of technology and society, and challenges in fintech, committed to promoting the application and sustainable development of cutting-edge technologies like blockchain.