"Underestimated" ambition! Interpreting the Hong Kong Cryptocurrency Consultation Document, Three Ch

On February 20, 2023, the Hong Kong Securities Regulatory Commission issued the “Consultation Document” on

cryptocurrency

transactions, marking an important step taken by the Hong Kong government in liberalizing the field of cryptocurrency transactions. At first, the author did not have high expectations for the “Consultation Document”. 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 the author read the entire “Consultation Document” that I realized that I had underestimated the will and ambition of the Hong Kong government. In order to better interpret the “Consultation Document”, this article analyzes the framework blueprint, opportunities and challenges from three aspects.

1. The future blueprint of the cryptocurrency market in Hong Kong

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 Document” can be regarded as a draft of the actual implementation of the bill, and it 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 Document”. This “Consultation Document” contains three important framework system designs: dual licenses, access arrangements and prohibited items.

1. Dual license

According to the provisions of Part IV of the “Consultation Document” (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 “Anti-Money Laundering Ordinance” under the VASP license.

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

In order to simplify the procedure, the “Consultation Document” 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, the author is quite surprised this time. According to the original expectation, the access arrangement is expected to be “allowing Hong Kong residents to buy and sell mainstream cryptocurrencies”. This sentence 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; It is a type of transaction that 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 Document is more open.

First of all, in terms of users, apart from the well-known “allowing retail investors to participate in transactions”, the “Consultation Document” 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 countries and regions that are friendly to cryptocurrency or have no relevant laws and regulations, such as Japan, Singapore, and Turkey, In principle, the platform can be developed.

Secondly, on the asset side, the “Consultation Document” 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 Document” stipulates that “before a platform operator includes any virtual assets for trading (whether or not provided to retail customers), it should first conduct all reasonable due diligence on such virtual assets” (see the “Guidelines for specific review content”) “7.5). 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 7.9 of the Guidelines, 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 16.4 of the “Guidelines”, virtual assets that are only for professional investors to buy and sell only need to notify the Securities Regulatory Commission in advance, without the approval of the Securities Regulatory Commission. However, for assets sold to retail investors, 16.3 of the “Guidelines” requires 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, “before being included for retail users to buy and sell. Should have been included in at least two or accepted indexes launched by at least two index providers ”, 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 Securities Regulatory Commission; but for retail investors On the one hand, 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 the authors point of view, the top five or even top ten cryptocurrencies by market capitalization are all likely to be selected.

However, the “Consultation Document” stipulates that for retail investors, the Securities Regulatory Commission 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 Securities Regulatory Commission. 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. A typical case 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 why the Japanese market cannot main reason for its development.

Overall, in terms of access arrangements, the Hong Kong government‘s opening up has exceeded the author’s expectations, but we can also see from some detailed designs that the Hong Kong Securities Regulatory Commission is not in control of how to balance market prosperity and investor protection. Facing certain challenges.

3. Prohibition

The Consultation Document clearly stipulates that,

Platform operators should not publish any advertisements about 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 7.23 of the Guidelines);

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 ways One is to set up a sub-station or an independent subsidiary in Hong Kong.

It should be noted that the Hong Kong Securities Regulatory Commission 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.

2. Future opportunities in the cryptocurrency market in Hong Kong

After the release of the Consultation Document, 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 Document” 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 Document” 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 Document” 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 in Canaan 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 Document” 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.

3. Future challenges in the Hong Kong cryptocurrency market

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

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 Document. It should be noted that this issue involves the supervision of commercial banks and requires the cooperation and cooperation of the Hong Kong Securities Regulatory Commission 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

At present, 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 Document.

3. Financial soundness issues

According to the provisions of 6.3 of the “Guidelines”, “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 FTXs bankruptcy. Therefore, in terms of financial soundness, the China Securities Regulatory Commission may need to make special regulations on liquidity supervision.

Fourth, write at the end of the text

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 “Consultation Document” 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.