Hong Kong Web3, stumbling forward

Written by: Gyro Finance

On April 30, six Hong Kong virtual asset spot ETFs were officially listed on the Hong Kong Stock Exchange, marking their market debut.

The previous week, the Hong Kong Securities and Futures Commission (SFC) had already listed the Bitcoin and Ethereum spot ETFs from three fund companies: Huaxia Fund (Hong Kong), Bosera International, and Harvest Global Investments, and gradually disclosed the issuance information.

In terms of issuance price, the products under Harvest Global Investments and Huaxia (Hong Kong) were priced at 1 USD (7.827 HKD) per share, while the initial issuance prices of Bosera's Bitcoin ETF and Ethereum ETF were roughly consistent with 1/10000 and 1/1000 of the tracking index as of April 26, 2024, meaning that holding 10,000 shares is approximately equivalent to 1 Bitcoin, and 1,000 shares is approximately equivalent to 1 Ethereum.

Opening prices of the six ETFs, source: public data

From the debut results, the performance of Hong Kong ETFs can only be described as mediocre. By the close of trading, the total transaction amount for the first batch of six Bitcoin and Ethereum spot ETFs launched in Hong Kong was only 87.58 million HKD, with most ETFs falling below their opening prices. For example, the largest Huaxia Bitcoin ETF opened at 8.07 HKD but closed at only 7.95 HKD. In stark contrast, the trading volume on the first trading day of the 11 US spot Bitcoin ETFs reached 4.6 billion USD, approximately 383 times that of Hong Kong's first day.

Since the declaration of virtual assets in Hong Kong, the crypto industry has had high hopes for the region. Now, a year later, Hong Kong has made significant strides, yet the results remain lackluster, leading to the market coining the phrase "loud thunder, little rain" to describe Hong Kong's Web3.

In fact, signs of this situation were evident early on. When the first batch of virtual asset ETFs was publicly announced as approved on April 15, discussions within the industry were mixed.

Although major mainstream media platforms hailed it as a historic event, the market's response was telling. Both Bitcoin and Ethereum prices remained volatile or even slightly declined, with little impact from the news. In contrast, during the hype surrounding the US Bitcoin spot ETFs, whether through the initial surge of the market or the subsequent brief drop in Bitcoin prices, or even Bitcoin breaking new highs, all demonstrated the substantial influence the US has on the crypto market, an influence that Hong Kong undoubtedly struggles to match.

The root of this challenge lies in the scale of capital. Since the news of the approval of Hong Kong's spot ETFs emerged, there has been much speculation about the capital flow into the ETFs. Eric Balchunas, a senior ETF analyst at Bloomberg, publicly stated on the X platform that due to the approximately 52 billion USD market size of Hong Kong ETFs, combined with institutional capital management restrictions and insufficient liquidity in Hong Kong's foundational ecosystem, attracting 500 million USD to all virtual asset spot ETFs in Hong Kong would already be considered an excellent performance.

Some industry insiders disagreed, arguing that the institutional effect in Hong Kong's ETF market is significant, and the high recognition of virtual assets may still provide opportunities for a turnaround. For comparison, the AUM of the SPDR GOLD TRUST in the Hong Kong market has reached 69.8 billion USD, indicating a strong outlook for inflation-resistant assets. Another example comes from Chainalysis, which estimated that from June 2022 to June 2023, Hong Kong's active over-the-counter cryptocurrency market drove 64 billion USD in trading volume. In this regard, Wayne Huang, the project leader of OSLETF, believes that this ETF should at least attract 1 billion USD, while Paolo from the crypto exchange VDX even thinks that 10 billion USD could be introduced this year.

From the current trading situation, the transaction scale is still not optimistic, with the first-day trading volume not reaching 100 million, while observing the futures ETFs listed in Hong Kong, three ETFs only attracted 529 million HKD in capital inflow. Of course, given the limitations of futures, this figure can only serve as a lower bound valuation.

Returning to the essence, the market is most concerned about whether the southbound capital channel can be opened. Mainland Chinese capital and Hong Kong investors need to use the Stock Connect programs to invest in each other's markets, leading to the terms southbound capital (from Mainland China to Hong Kong) and northbound capital (from Hong Kong to Mainland China). In short, the flow of money from the mainland into Hong Kong is widely regarded as the key to the rise of crypto in Hong Kong.

Regarding this issue, even core participants in the ETFs do not have a definitive answer. The primary compliance of ETFs comes from the underlying assets, and currently, the targets of Hong Kong's spot ETFs are virtual assets like Bitcoin and Ethereum, while trading in virtual assets is strictly prohibited in the mainland. Therefore, many issuers have stated that southbound capital finds it difficult to purchase ETFs. Caixin also reported that according to a joint circular issued by the Hong Kong SFC and the Hong Kong Monetary Authority in December 2023, neither the existing virtual asset futures ETFs in the Hong Kong market nor the future virtual asset spot ETFs can be sold to retail investors in Mainland China, where the sale of virtual asset-related products is prohibited.

However, there are exceptions; individuals from the mainland holding a Hong Kong ID, even if not permanent residents, can participate in the trading of the aforementioned ETFs under compliant conditions. Based on this information, mainland institutions or individuals holding IDs from both regions may also have opportunities to participate, although whether there are gray areas remains unclear. A somewhat ambiguous indication is that all currently approved virtual asset spot issuers show signs of Chinese capital involvement, and the two ETFs under Huaxia not only have HKD and USD counters but also added a RMB counter.

Issuance data of the six ETFs, source: public data

However, from the practical operations of mainland users today, investors from the mainland receive pop-up messages indicating that their transactions are rejected when attempting to purchase ETFs. Therefore, under the current circumstances, the influx of southbound capital remains challenging, with offshore capital and local capital becoming the primary regions for the sale of Hong Kong's virtual asset spot ETFs.

Pop-up message for mainland users on Tiger Brokers, source: X platform

Beyond scale, the local crypto market in Hong Kong still faces numerous issues. High costs and a small market make it difficult for Hong Kong to develop a large technological ecosystem, let alone discover large-scale application projects. As a channel for capital exchange, this clearly aligns more with Hong Kong's positioning, but this channel is not only subject to regulatory restrictions but also faces challenges from other markets. For example, offshore capital can choose cheaper overseas exchanges, which directly leads to the market's nearly tepid response.

Even if the market is not optimistic, the very existence of ETFs holds more profound significance for Hong Kong as a financial center. Although the Hong Kong government has vehemently denied claims of being a financial center relic, data shows that Hong Kong has significant advantages in markets such as bonds and wealth management, as well as in sub-sectors like banking and insurance. However, it must be acknowledged that in recent years, under the pressures of a tightening macro environment and the rise of overseas markets, Hong Kong's international competitiveness has still been under strain.

Taking the stock market, which is the most controversial, as an example, the lack of liquidity in Hong Kong stocks has become an acknowledged fact. Data shows that in 2023, the number of IPOs on the Hong Kong Stock Exchange was 73, a decrease of 19% year-on-year, with total IPO fundraising amounting to 46.295 billion HKD, a decrease of 56% year-on-year. Not only did the fundraising scale hit a ten-year low, dropping Hong Kong out of the top five global IPO markets, but among the 73 newly listed stocks, 36 saw their prices fall below the issue price on the first day, resulting in a 51% rate of decline.

Against this backdrop, virtual assets, as a major representative of the foreseeable financial sector of digital assets, are undeniably crucial for the international financial center's strategic layout. The example of the US virtual asset ETFs has already demonstrated this; in less than four months, the asset management scale of the 11 US Bitcoin spot ETFs has exceeded 52 billion USD. Currently, it seems that Hong Kong's efforts have not been entirely in vain. At least in terms of regional competition, apart from the dominance of the US, a tripartite balance of power has emerged among Dubai, Singapore, and Hong Kong, with proven capital and talent flows gradually entering Hong Kong as the ecosystem is established and ETFs are launched.

From an industry perspective, the approval of ETFs in Hong Kong has significantly promoted the compliance of virtual assets and added momentum to the development of the crypto industry in Hong Kong. Specifically, ETFs greatly enhance the convenience of purchasing for investors; products that previously required opening accounts at compliant exchanges can now be directly traded through securities accounts and banks after the ETFs are listed, allowing retail investors to participate directly. Institutions or funds that find it difficult to invest directly in virtual assets due to regulatory constraints can also participate indirectly through ETFs.

"Investors in Hong Kong can buy ETFs just like purchasing stocks; now firms like Interactive Brokers, Tiger Brokers, and Victory are all supporting purchases," said a worker in Hong Kong. In contrast, purchasing US virtual asset ETFs requires being a professional investor in Hong Kong, with investment amount thresholds.

It is worth mentioning that Hong Kong's acceptance of physical redemption allows for a more flexible trading model for virtual asset ETFs, supporting various transaction types such as crypto in, cash out; crypto in, crypto out; cash in, crypto out; and cash in, cash out. This contrasts with the US, which only allows cash in, cash out for redemptions, increasing the potential for arbitrage mechanisms and facilitating participation from native crypto users.

Returning to the ETFs launched this time, the fee war that originally ignited in the US seems to have subtly restarted in Hong Kong.

Due to the same underlying assets being tracked, investors will focus on fee ratios and liquidity when choosing ETFs. Theoretically, the fee ratios of ETFs on the Hong Kong side should be higher than those in the US, as the compliance costs for crypto exchanges in Hong Kong are higher than those overseas. For example, in addition to fixed costs such as operations, technology, RO, and data tracking, there are also linearly increasing custodial asset insurance costs. This hidden high cost can be seen from the listing fees; according to official data, the relatively weak liquidity HashKey Exchange estimates its listing fees to be between 50,000 and 300,000 USD, while Coinbase claims it does not charge listing application fees but reserves the right to charge such fees for evaluation and services during the listing process.

The facts align with the data; according to product summaries, the fee ratios of the three institutional ETF products are all higher than those of comparable ETFs in the US, with Huaxia's ETF product having the highest fee ratio at 1.99%, followed by Harvest and Bosera at 1% and 0.85%, respectively.

Currently, to attract capital, Hong Kong has made concessions in management fees, with major issuers hoping to gain scale advantages through lower management fees. Statistics show that the management fees for the three funds are 30 basis points for Harvest Global Investments, 60 basis points for Bosera International, and 99 basis points for Huaxia Fund. Among them, Harvest Global Investments' products waive management fees for six months, Bosera International's products waive management fees for four months after issuance, while Huaxia's internal assessment indicates that the management fee rate can be reduced to 65 basis points.

Comparison of the three issuing institutions, source: TechubNews

Compared to the US, the management fee rates of Hong Kong ETFs still appear relatively high and lack core competitiveness. Data shows that, apart from Grayscale and Hashdex, the fee rates of the other nine approved Bitcoin ETFs in the US range from 0.19% to 0.49%, with the representative product, BlackRock's iShares, having a fee rate of 0.25% and only 0.12% in the first 12 months. However, it is noteworthy that even though Grayscale's fee rate is as high as 1.5% and has seen continuous outflows of funds in recent months, it remains the ETF institution with the highest asset management scale, reflecting the importance of liquidity for ETFs themselves.

Reflecting on actual transaction data, the high fee but asset management scale advantage of Huaxia shows a leading effect. Data shows that the initial scale of Huaxia's Bitcoin ETF and Huaxia's Ethereum ETF was 950 million HKD and 160 million HKD, respectively, while in the first day's trading volume, the Huaxia series accounted for nearly 57%.

Although it seems precarious, Hong Kong may have anticipated this situation from the very beginning.

A head of a Hong Kong crypto exchange stated, "We cannot compare with the US, but compared to similar products in Europe, Canada, Switzerland, and other regions, Hong Kong still holds an absolute advantage. Hong Kong can serve as a pivot to develop towards Southeast Asia, Taiwan, and even the Middle East. After compliance, traditional capital will enter cautiously; the ETF market will definitely exist, but it is difficult for compliant exchanges in Hong Kong to rise in the short term."

From a differentiation perspective, in addition to more active capital and the advantages of physical asset subscriptions, Hong Kong's stringent compliance has also created a safer and more controllable trading environment. For example, according to the Hong Kong SFC regulations, crypto exchanges must insure all custodial assets, and user assets must achieve cold-hot separation, with 98% placed in cold wallets and only 2% in hot wallets. If a cold wallet is lost, over 50% compensation can be obtained, while a loss of a hot wallet results in full compensation. In this context, traditional capital in the Asia-Pacific region, which is highly risk-averse, can also enter the market with peace of mind.

Another advantage is the Ethereum spot ETF. Currently, the Ethereum spot ETF in the US is still in contention, with mixed messages surrounding its approval. From the perspective of approval, most believe that with the Ethereum futures ETF already approved, the SEC would find it difficult to justify a rejection. Additionally, whale accounts led by Sun Yuchen have begun to accumulate ETH. However, from the rejection perspective, the security nature of Ethereum and the SEC's tough stance have left the market feeling hesitant. Recently, according to four informed sources, US issuers and other companies expect the SEC to reject the applications for Ethereum spot ETFs, claiming that after discussions between issuers and the SEC, the SEC's attitude has been wavering, and staff did not discuss the execution details of this financial product, in stark contrast to the previous intensive and detailed discussions regarding Bitcoin spot ETFs.

This may also present certain opportunities for Hong Kong's ETFs. When the ETFs were approved, Hong Kong simultaneously approved both Bitcoin and Ethereum spot products, directly filling the gap left by the US regarding Ethereum ETFs, although as of today, the ETH product has only seen approximately 20.09 million HKD in trading volume.

Considering various reasons, issuers remain quite confident; Huaxia Fund has purchased insurance worth up to 1 billion USD for its assets, reflecting expectations for market scale. The CEO of Harvest Global Investments, Han Tongli, even stated in an interview, "Hong Kong ETFs should not be inferior to any US ETF and may even surpass them."

Currently, regarding the inflow of funds into ETFs, there are market rumors and endorsements suggesting amounts of 500 million, 1 billion, 10 billion, or even 20 billion USD, but based solely on today's market performance, regardless of the figure, all still await the test of time.

Interestingly, viewing Hong Kong's crypto landscape from different perspectives yields vastly different results. When the declaration was released in 2022, everyone in the market had high expectations for Hong Kong, marking the rise of the East and the decline of the West. By 2023, after the new licensing regulations were issued, the compliance costs and stringent regulations led exchanges to admit they were "dancing with shackles," and market enthusiasm quickly waned, with neglect and observation becoming the prevailing attitudes. Now, with the listing of virtual asset ETFs this year, mixed opinions have begun to emerge. The only constant is that at every juncture, Hong Kong's crypto sector has risen accordingly, with news seemingly becoming a signal for secondary market speculation.

In response, a friend humorously remarked, "Have we placed too many expectations on Hong Kong, while Hong Kong has given back too little?"

It is still too early to say. In previous articles, I have referenced the number of listings to describe the current Hong Kong crypto industry. In reality, even without deliberate description, it is clear that Hong Kong's crypto sector, after experiencing an ecological loss in 2017 and 2018, is slowly and painstakingly entering a new era of compliance. The competition among compliant exchanges, offshore exchanges, and brokerage firms is just beginning to set sail, and in terms of public education and market cultivation, Hong Kong is still in its early stages.

At the next juncture, what position will the crypto industry hold in Hong Kong? The answer remains uncertain. However, from the current situation, the Chinese Web3 will always occupy a place, and the Asia-Pacific market will ultimately be one of the key markets for crypto, requiring windows and pivots to support this market and community. Moreover, considering the potential emergence of large-scale digital asset exchanges in the future, it can be said that the future of crypto in Hong Kong is still vast, at least much larger than the data we see now.

The footnotes of history have been set; the future of Hong Kong's Web3 is slowly but surely on its way.