The dawn of Web3 in Hong Kong comes quietly

Author: Yin Ning

Produced by: Gyroscope Research Institute

The highly anticipated new cryptocurrency regulations in Hong Kong have finally been established.

On May 23, the Hong Kong Securities and Futures Commission (SFC) released the "Consultation Summary on Proposed Regulatory Framework for Virtual Asset Trading Platform Operators Licensed by the Securities and Futures Commission," providing a complete disclosure of the previously conducted consultation cases. Based on this, on the 25th, the SFC published the "Guidelines for Virtual Asset Trading Platform Operators" and "Guidelines for Anti-Money Laundering," both of which took effect on June 1.

However, compared to the strong momentum of Hong Kong's cryptocurrency concept in April, the market's expectations were not as high when the policy was finally implemented, and the anticipated lively discussions did not materialize. Within the industry, apart from mainstream exchanges promoting their licenses, only footage from CCTV lingered on the homepages of crypto retail investors.

In a lukewarm market environment, the tightening of compliance licenses, restrictions on retail investment, and the ambiguity of mainland channels have made the attractiveness of Hong Kong's policies seem elusive like mist. Coincidentally, the U.S. accusations against Binance and Coinbase have led to a gradual chaos in regulatory affairs, intensifying speculation between the East and West.

Amidst the confusion, the dawn of Hong Kong's cryptocurrency policy is quietly approaching.

I. Hong Kong Regulation: Early Start, Late Arrival

As a typical rule-of-law capital, the establishment of Hong Kong's policies emphasizes the principle of "same business, same risk, same rules." The introduction of this new regulation combines consistency with innovation, integrating virtual asset trading with traditional finance into a unified framework, subject to regulation based on business and risk attributes.

From a policy perspective, as early as 2017, when the cryptocurrency field was still chaotic, Hong Kong had already begun to pay attention to this area by issuing the "Statement on Initial Coin Offerings" and the "Circular to Licensed Corporations and Registered Institutions Regarding Bitcoin Futures Contracts and Investment Products Related to Cryptocurrencies," clearly defining the regulatory targets and taking the lead in establishing the regulation of cryptocurrencies and futures contracts with securities characteristics.

In 2018, in response to tightening regulations in mainland China, Hong Kong promptly expanded its regulatory scope by issuing the "Statement on the Regulatory Framework for Management Companies, Fund Distributors, and Trading Platform Operators Targeting Virtual Asset Investment Portfolios," bringing virtual asset management businesses under regulation and including cryptocurrency exchanges and other operating platforms in a sandbox.

In 2019, Hong Kong established a licensing development framework through the "Standard Terms and Conditions Applicable to Licensed Corporations Managing Investment Portfolios in Virtual Assets" and the "Position Paper: Regulating Virtual Asset Trading Platforms."

To this day, from the perspective of the new regulations, the core of Hong Kong's cryptocurrency policy has not changed; it still prioritizes investor protection, refining and optimizing definitions and scopes within the existing framework. Aside from necessary AML, compliance requirements, and risk management, the two most significant differences from the previous compliance framework are the licensing acquisition method and the expansion of investment categories.

Under the previous cryptocurrency framework, Hong Kong focused on centralized virtual asset trading platforms providing securities-type token trading services, where platforms could voluntarily choose whether to obtain a license, and non-securities-type tokens were not regulated. However, under the new regulations, all virtual asset trading platforms operating in Hong Kong or actively promoting their services to Hong Kong investors must obtain a license from the SFC and be regulated, regardless of whether they provide securities-type token trading services.

Existing exchanges have a 9-month application period during which they can operate normally and have a 12-month grace period for compliance. Institutions that do not hold a license and do not intend to apply will face withdrawal after June 1, and failure to withdraw will result in legal liabilities.

In simple terms, those with licenses can stay, while those without must go.

Regarding the required licenses, the existing licenses for securities-type tokens are License 1 and License 7, while under the new regulations, a VASP license has been added for non-securities-type tokens. This means that exchanges after June 1 need to obtain License 1, License 7, and the VASP license simultaneously, further increasing compliance pressure under the dual licensing mechanism.

On the other hand, previously licensed exchanges could only open to professional investors (individual assets of no less than 8 million HKD, institutional assets of no less than 40 million HKD), while the opening to retail investors will be implemented in the second half of the year. At that time, licensed exchanges will be able to provide trading services to retail investors, but the SFC stipulates that the tokens must be included in at least two acceptable, investable indices provided by independent vendors, and only highly liquid non-securities-type tokens will be considered for inclusion. Currently, only over ten tokens, including BTC, ETH, LTC, DOT, LINK, BCH, Solana, Cardano, Avalanche, and Polygon, meet the requirements. However, with the recent classification of all tokens except BTC, ETH, and USD-related tokens as securities by the U.S. SEC, the specific determinations still await Hong Kong's actions in the second half of the year.

It is worth noting that some aspects of the policy remain unclear. Stablecoins have not yet been included and will have regulatory arrangements implemented in 2023/24, while NFTs, due to their difficult-to-define nature, have not been explicitly mentioned in the framework. However, this can be compared to the EU's MiCA, which, although not mentioning NFTs, still falls under the SFC's regulation due to its financial attributes.

Looking back at Hong Kong's policy path, it can be said that it started early but arrived late.

In 2017 and 2018, when mainstream regions like Singapore and Europe were still in the exploratory and observational stages, Hong Kong had already formed a basic framework, giving rise to representative enterprises like FTX and Bitmax. However, it was precisely because of the premature establishment of regulatory mechanisms, combined with the government's principle of free development in this field, that the still-chaotic cryptocurrency sector entered a new era of exploration. Users, enterprises, and institutions gradually migrated to Western countries, diminishing the cryptocurrency discourse power in the East. Singapore emerged as a springboard for the West, while countries like Dubai, the UK, Japan, and South Korea rushed to formulate strategies to seize the market.

Although Hong Kong still lacks the authority to formulate global virtual asset rules compared to mainstream countries like the U.S., and its new regulations are relatively conservative, it can be considered the first region in the world to clearly define boundaries on issues such as retail investors, KYC, and token listings. Especially against the backdrop of Singapore's ambiguous stance and the U.S.'s selective enforcement, Hong Kong's cryptocurrency framework undoubtedly possesses foresight and openness.

However, in the face of this rare policy window, the market's reaction has been somewhat tepid.

II. Market Indifference: Stricter Compliance, Unclear Channels

On May 24, a 1 minute and 38 seconds short video circulated widely in the crypto community, announcing that the Hong Kong SFC had declared that all preparations for virtual asset trading in Hong Kong were basically complete, and that starting June 1, the SFC would implement a mandatory licensing system for virtual asset trading platforms.

In the crypto community's interpretation, this video was seen as a significant move by the mainland to support cryptocurrencies, providing an opportunity to attract new inflows. Many in the community used central support and the rise of BTC as selling points to attract new users; Zhao Changpeng also tweeted that historically, such actions would lead to a bull market, echoing sentiments of a market rebound.

But aside from that, there were no other ripples in the market.

The most direct manifestation is the price of cryptocurrencies, which perfectly illustrates the disconnect between hype and reality in the secondary market. Compared to the hundreds of times increase in Hong Kong concept coins during the April rally, this sector did not see any rise during the announcement of the new policy, and many were even in a downward trend. For example, the domestic public chain Conflux's CFX, which previously surged 197.3% due to the concept in April, had dropped 21.16% in the seven days leading up to June 9, and decreased 44.69% in the past 30 days. The licensed exchange Hashkey, which was directly benefited, saw its ecosystem token GARD, released by its capital arm Hashgard Community, drop 9.1% on May 25, and it continued to trend downward even on June 1.

Although the prevailing bear market is still primarily responsible, discussions among the public frequently mention compliance costs, the degree of retail opening, and the ambiguity of mainland channels, indicating a hesitant attitude towards Hong Kong's policies.

For exchanges, although obtaining a license is beneficial for first-mover advantage, the high compliance costs in Hong Kong have also become an important consideration for the market. Taking the typical License 7 as an example, compared to License 1 and the VASP license, License 7, which allows for automated trading services, is crucial for exchanges. However, the application process for License 7 is not simple; the costs during the application process can reach at least 300,000 HKD per month, requiring a complete IT system with mature configurations for trading, clearing, and custody. Additionally, shareholder financial assets and human resource costs are not insignificant; for example, at least two responsible officers (ROs) with virtual asset service experience must be appointed.

The operational costs after obtaining the license are even more expensive. For instance, in terms of insurance, Hong Kong requires licensed exchanges to purchase corresponding insurance to hedge risks, with industry costs typically around 2% per year, which is a considerable expense for large assets. OSL, a licensed exchange that has obtained both License 1 and License 7, disclosed in its 2022 financial report that the additional administrative and operational costs of 43.8 million HKD in the fiscal year were mainly for establishing corporate and technical infrastructure for digital asset businesses (including technology, legal and compliance, and insurance), totaling 89.8 million HKD.

"Compliance is merely the establishment of rules; it does not create a market. Applying for a license solely for compliance is unnecessary; one must consider where the market is." A senior industry insider expressed this view.

The actual market has already proven this statement; compliant exchanges in Hong Kong have severely limited survival space. Taking OSL as an example, the OSL digital asset platform reported an IFRS revenue of only 71.5 million HKD in the fiscal year 2022, with an annual total trading volume of 455.9 billion HKD, resulting in an average daily trading volume of about 1.3 billion HKD, which is significantly lower than leading exchanges. The high costs are also reflected in listing fees; market news indicates that the listing fees for physical assets on compliant exchanges in Hong Kong can reach several million USD, compared to only a few tens of thousands of USD on overseas compliant exchanges, highlighting the disadvantages.

Secondly, the positive impact of this policy on retail investors is also extremely limited. On one hand, the degree of retail opening remains insufficient, with expected restrictions on investable tokens, and the critical DeFi sector has not yet been clarified. How this sector will be included in retail investors' portfolios remains to be seen. On the other hand, trading costs are also a concern for retail investors. Compared to the compliance exchanges with costs as high as 3%, mainstream exchanges like Binance and OKX have rates generally below 1%, making the low fees of overseas exchanges more appealing.

Finally, there is the ambiguity regarding the opening of mainland channels.

Although there are no restrictions on inflows and outflows in the regulations, the inflow and outflow of HKD and cryptocurrencies should not be restricted. However, even if it carries part of the Southeast Asian and Japanese and Korean markets, the market capacity in Hong Kong is extremely limited, and the opening of broader mainland channels is key to becoming a window. From the current perspective, the financial sector does not seem to be convinced by the policy. Although the Hong Kong Monetary Authority (HKMA) has clearly stated that it will not set higher thresholds solely for virtual asset platforms, some smaller banks, such as ZhongAn, have publicly stated that they can accept crypto deposits, and there are reports of some state-owned banks actively engaging in crypto business. However, in actual operations, considering compliance costs and risk control, even licensed companies face difficulties in opening bank accounts. An executive from a crypto company holding a Type 9 license in Hong Kong stated, "We cannot open bank accounts in Hong Kong and can only choose to cooperate with overseas banks. We are unclear about what information the banks actually need, and the banks themselves are evidently not very clear either."

One side is actively introducing, while the other remains unmoved; the opposition between the two has led the industry to believe that consensus has not yet been reached. Senior analyst Phyrex@Phyrex_Ni candidly stated on Twitter, "The biggest problem in Hong Kong is not compliance. For risk assets, the local stock of funds is almost negligible. The real issue is who the main buying force in the cryptocurrency market is, and whether this force can take advantage of Hong Kong's compliance to come to the forefront. If so, it will inevitably lead to uncontrolled capital flow."

On the other side of the channel is Hong Kong's old money. The general consensus in the industry is that compliance will promote the involvement of traditional capital, but the reality is not without obstacles. Firstly, the old money in Hong Kong is highly conservative and takes a wait-and-see attitude towards cryptocurrencies. "There is an intention to enter, but for old money, the diversity of investment targets is high, and the cryptocurrency industry still has a high degree of uncertainty. Although some have established subsidiaries to test the waters, at this stage, there is still more observation than participation," said the head of a new economy division at a local asset management company. In terms of investment philosophy, old money also has significant differences; due to the tightly coupled real estate economy, local funds have limited understanding of technology companies and show a high recognition of platform profit models, lacking pricing power compared to overseas. This can be seen from the stock market, where Nasdaq favors high-tech stocks, while the Hong Kong market shows a preference for luxury and real estate stocks. A shift in perception will still take time. The entry of old money still has a time lag, adding a touch of calm to Hong Kong's current market.

III. Future of the Policy: A Spark Amidst the Flames

Under the influence of multiple factors, the enthusiasm for the policy appears somewhat subdued, but the spark brought by this policy is still spreading.

On one hand, the opening of Hong Kong to mainland capital is highly foreseeable, and mainstream exchanges have not given up on potential markets. Several leading exchanges have publicly announced plans to apply for virtual asset service provider licenses. For example, OKX's founder Xu Mingxing stated that OKX has been preparing to apply for a Hong Kong crypto license since 2022 and established a Hong Kong entity in March to officially launch virtual asset services in Hong Kong.

Old money is also showing signs of movement. Although most actions are pilot projects focusing on the secondary market, some traditional institutions are eyeing this field and taking action in the primary market by attempting to apply for licenses, such as asset management company Yibo Financial, brokerage firms Tiger Brokers and Interactive Brokers, among others. The project leader of a large local trust institution also told the author, "We are building a hybrid financial platform in preparation for applying for a license and are currently recruiting ROs."

On the other hand, Hong Kong's compliance seems to have stirred the murky waters of global regulation. The U.S. cryptocurrency situation is deteriorating, with political struggles and personal conflicts erupting. Recently, the U.S. SEC filed 13 charges against Binance and Zhao Changpeng, causing industry tremors and leading to rumors of a leadership change at Binance, with the successor reportedly responsible for compliance, raising speculation. Subsequently, another local giant, Coinbase, also found itself embroiled in legal troubles.

As the SEC classified as many as 67 cryptocurrencies as securities, the overall market dropped over 20% on June 10, with only BTC, ETH, and a few others remaining resilient. Given the political donations from FTX and the predominantly civil nature of the lawsuits, the industry has shown great distrust towards the timing and purpose of the SEC's actions, believing that this move is merely to alleviate financial pressure, shift conflicts, and vie for enforcement power. However, at its core, the SEC's accusations are not unfounded, as many tokens based on POS consensus do indeed have securities implications. Fortunately, there is also a positive side; the SEC's regulation may force Congress to clarify the attributes and framework of cryptocurrencies. In the long run, whether the U.S. actions will prompt other regions to follow suit and filter market participants through compliance remains to be seen, and under this backdrop, clarifying regulatory boundaries is particularly important.

Hong Kong, as a city that has proposed a complete and clear cryptocurrency framework, has already taken the lead in compliance even on a global scale. However, mere compliance is far from sufficient; there are not many places globally that can achieve compliance. Under high costs, attracting the flow of people and capital that cryptocurrencies bring requires interconnected industries, supportive awareness, and tangible capital channels to go further.

In this regard, Hong Kong is clearly taking action, with green bonds, digital HKD, and the Web3 Association all demonstrating determination. In response to U.S. regulation, Hong Kong Legislative Council member Wu Jiezhuang tweeted that he welcomes global virtual asset exchanges (including Coinbase) to apply for compliant trading in Hong Kong and discuss listing plans, and he is willing to provide assistance. The Deputy Secretary for Financial Services and the Treasury of the Hong Kong government, Chen Haolian, also stated that the Hong Kong government is actively participating in the virtual asset value chain, aiming to launch a regulatory framework for stablecoins by the end of next year.

It is important to emphasize that whether it is a clear framework or strong regulation, compliance is an inevitable product of the industry's development to a certain stage. Describing it solely from the perspective of benefits and drawbacks is meaningless. Only under the premise of compliance and security guarantees will off-market funds consider entering, as for traditional finance with a market value of trillions, the trillion-scale cryptocurrency market is merely a drop in the bucket.

After experiencing the quiet dawn, will Hong Kong's Web3 welcome the noisy daylight?

The East and West are in a century-long race in cryptocurrency, and the outcome remains unpredictable.