Author: MetaLab William

On December 22, 2023, the Securities and Futures Commission of Hong Kong issued the "Joint Circular on Virtual Asset-Related Activities of Intermediaries" (hereinafter referred to as the "Joint Circular") and the "Circular on Fund Investment in Virtual Assets Recognized by the Securities and Futures Commission" (hereinafter referred to as the "Fund Circular"), and stated that they are "ready to accept applications for the approval of virtual asset spot ETFs." So, what are the regulatory requirements for issuing Bitcoin spot ETFs in Hong Kong? What impact will it have in the future? This article will provide a detailed analysis.

I. Interpretation of the Conditions for Issuing Virtual Asset Spot ETFs

Overall, the issuance of the product needs to meet the requirements of the "Hong Kong Code on Unit Trusts and Mutual Funds + Joint Circular + Fund Circular." The first document mainly involves traditional regulatory requirements, as ETFs in Hong Kong are mainly issued through unit trusts, although in recent years, there have also been ETFs issued through open-ended fund companies (OFC), but we will not elaborate on this here. As for the "Joint Circular," it mainly introduces the regulatory requirements for virtual asset distribution, trading, asset management, and advisory, with a wide scope, so we will only introduce the policy part related to BTC spot ETFs. Regarding the "Fund Circular," it explicitly stipulates that the regulatory scope covers (1) public offering and (2) funds that invest 10% or more of their total assets in virtual currencies, including Bitcoin spot ETFs, so we will focus on this.

In detail, the issuance requirements are as follows:

1. Qualifications of the Issuer

Unlike the lack of specific requirements for the issuer of Bitcoin spot ETFs by the U.S. SEC, the Hong Kong SFC has imposed relatively strict regulatory requirements on the issuer—asset management companies issuing virtual asset fund products need to meet the following three conditions:

• Good regulatory compliance record. This means that asset management companies with a bad record are basically excluded, and as for newly established asset management companies, they face a certain degree of uncertainty. Therefore, well-established asset management companies in Hong Kong have a certain advantage in issuing BTC spot ETFs.

• The company must have at least one competent employee with experience in managing virtual assets and related products.

• The company needs to hold an upgraded Type 9 license. That is, the issuing company needs to meet the "Terms and Conditions Applicable to Licensed Corporations for Managing Portfolios Investing in Virtual Assets," and it should be noted that this document was revised in October 2023, lowering the application requirements and difficulty.

2. Underlying Asset Requirements

According to the circular, the underlying assets of virtual asset spot ETFs must be virtual assets that are currently tradable for retail users on licensed exchanges in Hong Kong. This means that BTC and ETH are the two virtual assets that can currently be issued as spot ETFs in Hong Kong.

3. Investment Strategy

Virtual asset spot ETFs are passive funds, so there are not many requirements for investment strategy. However, it should be noted that the circular states that the fund is not allowed to use leverage. The BTC spot ETF issuance document from BlackRock mentioned the role of Trade Credit Lender, which provides loan services for the ETF in certain scenarios. This role may be prohibited in Hong Kong.

4. Subscription and Redemption of Spot Virtual Assets and Trading

Currently, the issuance of virtual asset spot ETFs in Hong Kong allows for two modes: cash (Cash Model) and in-kind (In-Kind Model). The main reason is that the United States currently does not have specific regulations for virtual asset trading platforms. If in-kind subscription and redemption are accepted, criminals may use BTC to purchase ETFs directly to launder money. However, in Hong Kong, licensed exchanges require strict KYC/AML checks for depositing and withdrawing coins, so in-kind subscription and redemption through licensed exchanges can effectively avoid the problems faced by the U.S. market, but this also adds additional requirements to the Hong Kong market:

• Cash subscription and redemption must be conducted on licensed exchanges in Hong Kong, either on-platform or off-platform;

• In-kind subscription and redemption require the virtual assets to be transferred to licensed exchanges in Hong Kong or financial institutions recognized by the HKMA (Authorized Financial Institutions, AIs) and their subsidiaries;

• The trader participating in subscription and redemption (PD) needs to hold an upgraded Type 1 license.

5. Custody

Similar to trading, virtual assets require independent third-party custody, and the custodian must be a licensed exchange in Hong Kong or a financial institution recognized by the HKMA and its subsidiaries. In addition, the following arrangements need to be met:

• The custody account must be separate from the asset management company's own account;

• Most of the assets are placed in cold wallets, with a small portion in hot wallets for subscription and redemption;

• Secure storage of private keys, requiring the private keys to be kept in Hong Kong to effectively prevent external attacks and be appropriately backed up.

6. Valuation

In terms of valuation, the SFC has shown a lenient side. The index compilation used for valuation calculation does not require inclusion only from licensed exchanges in Hong Kong; it can be from major overseas exchanges. There are no special restrictions on index providers, only a requirement for good reputation.

7. Risk Disclosure and Investor Education

Both the "Joint Circular" and the "Fund Circular" are involved in this part, with the "Fund Circular" mainly covering risk disclosure in the issuance documents and financial reports; the "Joint Circular" mainly focuses on risk disclosure requirements in the distribution process. Of course, both circulars require the issuer and distributor to provide investor education.

8. Approval Process

According to the "Fund Circular," funds that are preparing to issue or plan to invest 10% or more of their total assets in virtual currencies must consult the SFC in advance and obtain approval.

9. Investor Restrictions

According to the "Joint Circular," the sale of virtual asset-related products must comply with the requirements of the relevant jurisdiction, meaning that the sale of virtual asset spot ETFs to investors in mainland China is prohibited.

II. Future Arrangements

From the above, it can be seen that the importance of the policy on virtual asset spot ETFs in Hong Kong is reflected in two aspects:

First, it clarifies the regulatory policy of the Hong Kong market for virtual asset spot ETFs. Unlike the unclear regulatory policy of the U.S. SEC, which has led to the approval process for related BTC spot ETFs taking more than six months, the Securities and Futures Commission of Hong Kong has made clear provisions for the issuance qualifications of related fund products, virtual asset trading, and custody.

Second, unlike the U.S. SEC, which only allows cash subscription and redemption (Cash Model), the Hong Kong SFC explicitly stipulates that both cash and in-kind subscription and redemption (In-Kind Model) are allowed (specific reasons will be analyzed later). This will make Hong Kong's BTC spot ETFs more advantageous compared to similar products in Europe and the United States.

Therefore, the author believes that the issuance of Bitcoin spot ETFs in Hong Kong is "all set and only awaits the east wind." The main regulatory obstacles have been eliminated, and the remaining issues are mainly technical details. The first Bitcoin spot ETF in Asia is expected to be launched in Hong Kong in the near future.

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