Can Hong Kong's big bet on digital assets lure crypto back?

Hong Kong was once an epicenter of crypto activity, but it's lost that status amidst a broader clampdown by Chinese authorities on digital assets and the more recent exodus of talent during several years of especially strict Covid-related quarantine measures.

In an effort to regain its standing, the province introduced a new licensing regime this year, betting that it can lure back developers and companies who left for Singapore and elsewhere.

But early returns look shaky. Crypto companies and their lawyers already want changes to the new licensing rules before they've even taken effect, arguing the proposed regime is too stringent and won't attract the caliber of companies needed to meet the government's goal of restoring the city as a digital assets center.

A limited pool of qualifying tokens that exchanges can offer retail investors, onerous cold storage requirements and unclear licensing rules are among concerns that industry members said they would highlight to the SFC in submissions to the consultation, people involved in drafting responses told The Block.

Hong Kong's Securities and Futures Commission first announced the new mandatory licensing regime for crypto exchanges and service providers last month and at the same relaxed a ban on crypto firms targeting retail investors. The planned changes were published as a public consultation, and industry members have until the end of March to respond with feedback. 

Hong Kong crypto ambitions

"It is important this regime is workable. There are some things that need tweaking and changing for it to work,'' said William Hallatt, partner at Gibson, Dunn & Crutcher. “It doesn't work well for anyone if you end up with a handful of smaller players.”

Getting the crypto licensing framework right is a key policy area for the city's government. Officials have staked a lot of energy and political goodwill on the asset class and the technology behind it, in an effort to win back the industry. Senior leaders regularly tout the city's crypto ambitions in meetings and at conferences. Partly, the sense of urgency comes from a realization there is still a chance to grab the crown as a respected regulated digital asset center while other markets, notably the U.S., struggle to work out how they want to handle the industry.

Just this week, Christopher Hui, Secretary for Financial Services and the Treasury, told the Aspen Digital Web 3 summit that 80 crypto service providers had shown interest in operating in Hong Kong since the new rules were proposed in late February. 

A successful regulatory regime would see crypto's development story go full circle given China and Hong Kong-based players were once leaders in the ecosystem until Beijing started clamping down in the late 2010s.  

"The public consultation is ongoing and the SFC will consider all views received and publish the consultation conclusions in due course," a spokesman for regulatory agency said.

License applicants

Among firms to publicly say they want to apply for the new license are BTSE, Huobi, JPEX and OKX. Bitmex, which has a large Hong Kong presence, declined to comment on its plans. Lawyers for the sector said several international exchanges were making inquiries without revealing their client names, arguing the city had immense appeal for globally minded firms given the volume of mainland Chinese customers already banked and investing in Hong Kong. Others who spoke to The Block said they expected large market makers might also apply. 

Under the proposed rules, digital asset service providers that already have a corporate structure in Hong Kong and do ''meaningful'' business in the city can apply for an exemption by a June 1 deadline, which gives them a further period to apply for the license or shut down their operation. Newcomers will need to apply for the license before doing any regulated business, similar to rules for traditional finance investment managers.

For the model to work, the city will require several big name firms in order to generate the liquidity needed, several people said. That might seem a hard ask given the negative headlines around some exchanges. Binance, for example, is under scrutiny in the U.S., and a recent report by CNBC suggests the company has helped customers circumvent Chinese mainland restrictions on digital assets. The licensing process, however, would give the SFC a chance to look under the hood and impose changes on how firms operate, one lawyer said.

Requested changes

Among issues flagged in the proposed rules were strict limits on the tokens and services licensed exchanges will be able to offer retails investors. Only “eligible large-cap virtual assets” that are included in major index-providers can be considered, according to current wording. That narrows the list down to a handful of tokens, people complained.

"There is an element here of the SFC saying we want to start small with retail and we don't want retail to take risks,'' said Hallatt. "They could just start with ether and bitcoin and gradually expand out."

Another bugbear is a requirement that 98% of client assets be held in cold storage, a ratio seen as too onerous given daily liquidity needs and the complexity of moving client money between cold and hot wallets. A 10% hot wallet limit would be more a manageable number that submissions should push for, one lawyer said. 

Token storage and the short list of digital currencies available for retail trading were both issues raised by the industry during a so-called soft consultation process that took place before the consultation document was published, one person involved in those talks told The Block. "It doesn't look like the SFC took those ideas in,'' she said, asking not to be identified speaking about confidential discussions with the regulator.

Joshua Chu, a digital assets lawyer and chief risk officer at Coinllectibles, said his submission will touch on the absence of futures trading, which remain off limits to retail investors under the proposed regulations. Crypto futures are a useful hedging tool though can also be used to make highly leveraged bets.

A further complaint was the mention in the consultation of crypto firms getting dual licensed under both the new digital asset regime and existing anti-money laundering provisions. The wording had alarmed some industry players who argued a single license under the digital asset rules already covered any AML concerns.

"The problem is you have no regulator globally that wants to be first off the ledge. It is like diving into the pool. You want to make sure the pool is deep enough so you don’t break your legs on the way down," said Hallatt.