Interpreting Hong Kong's Regulatory Framework for Bitcoin Spot ETFs

Author: MetaLab William

On December 22, 2023, the Securities and Futures Commission (SFC) of Hong Kong issued a “Joint circular on intermediaries virtual asset-related activities” and a “Circular on SFC-authorised funds with exposure to virtual assets”. In this announcement, the SFC expressed its readiness to accept applications for the approval of virtual asset spot ETFs. This article provides a detailed analysis of the regulatory requirements for launching Bitcoin spot ETFs in Hong Kong and explores the potential impacts.

I. Interpretation of Conditions for Issuing Virtual Asset Spot ETFs

In general, the issuance of products needs to meet the requirements of three regulatory documents: “Hong Kong Code on Unit Trusts and Mutual Funds,” “Joint Circular,” and “Fund Circular.” The first document mainly involves traditional regulatory requirements. As for the “Joint Circular,” it covers a wide range of regulatory requirements related to virtual asset distribution, trading, asset management, and advisory services. We will focus on the policy aspects related to BTC spot ETFs. Regarding the “Fund Circular,” it explicitly states that the regulatory scope includes funds that (1) are publicly offered and (2) invest 10% or more of their total assets in virtual assets, which includes Bitcoin spot ETFs.

Detailed issuance requirements are as follows:

1. Qualifications of the Issuer

Unlike the U.S. SEC, which does not explicitly specify the qualifications for issuers of Bitcoin spot ETFs, the Hong Kong SFC imposes strict regulatory requirements on asset management companies issuing virtual asset fund products. These companies need to meet the following three conditions:

● A good regulatory compliance record, meaning companies with a history of regulatory violations are essentially excluded. Newly established asset management companies face some uncertainty. Therefore, well-established 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. This means that the issuing company must meet the requirements of the “Terms and Conditions for Licensed Corporations Managing Portfolios that Invest in Virtual Assets,” which was modified in October 2023, reducing the application conditions and difficulty.

2. Underlying Asset Requirements

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

3. Investment Strategy

A virtual asset spot ETF is a passive fund, so there are not many requirements for the investment strategy. However, it is important to note that the circular specifies that the fund is not allowed to use leverage. BlackRock’s BTC spot ETF prospectus mentions the role of Trade Credit Lender, which provides loan services to the ETF in certain scenarios. This role may be prohibited in the Hong Kong market.

4. Application and Redemption of Spot Virtual Assets

Currently, the issuance of a virtual asset spot ETF in Hong Kong allows for both Cash Model and In-Kind Model. The main reason is that there are no specific regulations for virtual asset trading platforms in the United States. If in-kind redemption is accepted, criminals may use BTC to directly purchase ETFs to launder money. However, in Hong Kong, licensed exchanges require strict KYC/AML checks for depositing and withdrawing coins, effectively avoiding the problems faced by the U.S. market. But this also adds additional requirements for the Hong Kong market:

● Cash subscription and redemption must be conducted on licensed exchanges in Hong Kong, whether 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 Hong Kong Monetary Authority (HKMA) and their subsidiaries.

● Participants in subscription and redemption transactions (PD) must hold an upgraded Type 1 license.

5. Custody

Similar to trading, third-party independent custody of virtual assets is required, 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 must be met:

● Custodial accounts must be separate from the asset management company’s own accounts.

● Most assets are stored in cold wallets, with a small portion in hot wallets for subscription and redemption.

● Private keys must be securely stored, and the private key must be kept in Hong Kong, effectively preventing external attacks and ensuring proper backup.

6. Valuation

In terms of valuation, the SFC shows a lenient side. The index compilation used for valuation calculations does not require inclusion only from licensed exchanges in Hong Kong; it can include major overseas exchanges. There are no special restrictions on index providers, only that they must have a good reputation.

7. Risk Disclosure and Investor Education

Both the “Joint Circular” and the “Fund Circular” address risk disclosure. The “Fund Circular” mainly covers risk disclosure in prospectuses and financial reports, while the “Joint Circular” focuses on risk disclosure requirements in the distribution process. Both circulars require issuers and distributors to conduct investor education.

8. Approval Process

According to the “Fund Circular,” funds that plan to invest 10% or more of their total assets in virtual currencies must seek the opinion of 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. Therefore, the sale of Bitcoin spot ETFs is prohibited to investors in mainland China.

II. Future Arrangements

As seen from the above, the significance of Hong Kong’s policy on virtual asset spot ETFs lies in two aspects:

First, it clarifies the regulatory policy of the Hong Kong market for virtual asset spot ETFs. Unlike the unclear regulatory policies of the U.S. SEC, which have led to the prolonged approval process for related BTC spot ETFs, the SFC has made clear provisions on the qualifications of fund product issuers, virtual asset trading, and custody.

Second, unlike the U.S. SEC, which only allows Cash Model for subscriptions and redemptions, the Hong Kong SFC explicitly allows both Cash Model and In-Kind Model. This will make Hong Kong’s BTC spot ETF more advantageous than 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, only awaiting favorable winds.” 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 land in Hong Kong in the near future.