Hong Kong’s Ambitious And Difficult Cryptocurrency Foray

Executive Summary:

• Hong Kong’s Securities and Futures Commission (SFC) announced that 11 cryptocurrency exchanges are close to being licensed to operate in the city, aiming to establish Hong Kong as a leading digital assets hub. However, 12 exchanges did not advance in the licensing process, reflecting challenges in this sector.
• Since late 2022, Hong Kong has developed a robust regulatory framework for cryptocurrency, aiming to enhance transparency and investor protection. Key initiatives include licensing digital asset custodians and allowing exchange-traded funds (ETFs) with direct exposure to digital assets like Bitcoin and Ether.
• Despite Hong Kong’s efforts to revitalize its financial center status through cryptocurrency, competition from jurisdictions like Singapore and concerns over the technology’s volatility and association with illicit activities pose significant challenges.
• Beijing’s restrictions on mainland Chinese accessing cryptocurrency services in Hong Kong highlight the limitations of the One Country, Two Systems model. This constraint may dampen enthusiasm for operating in Hong Kong, as exchanges cannot serve the larger mainland market, potentially hindering the city’s growth as a cryptocurrency hub.

On June 1, Hong Kong’s Securities and Futures Commission (SFC) said on its website that 11 cryptocurrency exchanges are close to being licensed to operate in the city, which aims to become a leading digital assets hub and revivify itself as a global financial center (SFC.HK, June 1). The SFC describes this status as “deemed-to-be licensed,” and will eventually grant formal authorization to the exchanges to begin operations provided they satisfy compliance requirements. June 1 was a deadline the regulator set a year ago for exchanges to either be licensed or deemed to be. There are two digital asset exchanges that received licenses to operate in Hong Kong previously: OSL, in Dec. 2020, and HashKey, in Nov. 2022.

12 exchanges did not advance in the licensing process, illustrating the challenges Hong Kong faces in its bid to become a digital assets hub. Of these, 11 withdrew their respective bids, while one application was returned by the SFC. Many of the exchanges that will withdraw from Hong Kong have strong ties to the People’s Republic of China (PRC) mainland. They include Huobi (火币; HTX), BitHarbour (幣風港), QuanX Lab (全毅科技), Willows Asia Technology Company (永浩亚洲科技), AMMBR (HK), and Gate Digital. The regulator does not explain why their bids failed, but misaligned expectations about the potential to serve the mainland market—where investing in cryptocurrency is not permitted—likely played a role (SCMP, May 29).

Beijing’s willingness to allow Hong Kong to experiment with digital assets but not provide those services to the mainland underscores both the flexibility and limitations of the One Country, Two Systems model under which the territory is governed. Competition from Singapore and other jurisdictions with fewer ambiguities in their digital assets policies has pushed Hong Kong to reinvent itself as a financial center but is likely to face mounting challenges.

Reviving A Financial Center

As a major financial center, Hong Kong has had an active cryptocurrency market for more than a decade. In early 2014, long before the digital assets craze began, one of the world’s first Bitcoin ATMs was installed in Hong Kong (Business Next, January 5, 2014). Shortly thereafter, a local exchange called HXCEx said that it planned to launch one of the world’s first Bitcoin ATM networks in the city (Hxtop.com, February 27, 2014). The exchange operates today as HKCEXP, and since March has been under investigation for suspected fraudulent activities (SFC.HK, March 25).

The Hong Kong government did implement some limited digital assets regulations in the 2010s, but the government policy to develop the city as a center for cryptocurrency began about two and a half years ago when the city abandoned its strict pandemic controls that had largely imitated those in the mainland. At the time, Hong Kong was reeling from the combined impact of harsh national security legislation rammed through its legislature in June 2020 by Beijing, which significantly undermined confidence in its legal system and business environment, and the zero-Covid policy that severely disrupted life in the territory. Though these factors have not affected mainland immigration, which continues to grow, expatriates from some countries, such as France and Japan, are leaving the city (Nikkei Asia, February 20; SCMP, September 21, 2023). Adam Michael Toctan, a Hong Kong-based recruiter, said that many foreigners left Hong Kong due to the severity of the pandemic restrictions, causing “a brain drain” in the city (VOA Cantonese, December 7, 2023).

The Hong Kong government outlined its new pro-cryptocurrency outlook in a policy paper published in late 2022. “We recognize VA [virtual assets] is here to stay, given how it has attracted attention of global investors and is increasingly viewed as a conduit for financial innovations,” the paper said. It further stated that Hong Kong’s financial regulators believe that blockchain technology and Web3 (the nascent third iteration of the internet for which cryptocurrency is a building block) have the potential “to become the future of finance and commerce.” If properly regulated, the digital assets ecosystem will “reduce or resolve existing frictions across clearing, settlement and payments,” the paper added (HKSAR Government, October 31, 2022).

Subsequent scandals in the digital assets sector, including the dramatic collapse in November 2022 of the FTX exchange once valued at $32 billion, have not shaken Hong Kong’s resolve to develop its cryptocurrency sector. Even scandals within the Hong Kong crypto community itself have not deterred regulators. Last year, the unregulated JPEX exchange defrauded investors of HK$1.6 billion (US$204.6 million) in the largest fraud case in Hong Kong’s history (Blockcast.it, January 31). The case illustrated how cryptocurrency crime is evolving, as the exchange spent heavily on advertising to shore up its credentials with retail investors and even served as a sponsor of Token2049, a major industry conference in Singapore held in September 2023. After Hong Kong’s SFC issued a warning that JPEX was an unlicensed exchange, the company’s representatives vacated the conference booth and disappeared from the event (Business Next, September 15, 2023)., Meanwhile, the Hong Koing government remains undeterred. In June 2023, Hong Kong Financial Secretary Paul Chan wrote in a blog post that recent bankruptcies in the sector highlighted the importance of having greater transparency and regulation (CryptoNews CN, June 26, 2023).

Hong Kong’s embrace of cryptocurrency, however, suggests concerns about competitiveness, in view of the new technology’s volatility and association with illicit financial flows. There has not been a marked exodus of financial services firms from Hong Kong, and officials have denied the city’s status as an international financial center is in jeopardy (Economic Daily, December 17, 2023). Nevertheless, in the most recent Global Financial Center Index (GFCI) report, Singapore remained ahead of Hong Kong as the top financial center in Asia and third globally (HK01, March 22). It surpassed Hong Kong for the first time in this influential index in 2022.

Regulatory Progress Gains Traction

Since late 2022, the Hong Kong government has been working to develop a regulatory framework for cryptocurrency. It believes that a solid regulatory foundation is essential for the industry to thrive in Hong Kong. In some cases, Hong Kong has become a leader in digital asset regulations. For instance, in December 2023, Hong Kong’s SFC and the Hong Kong Monetary Authority (HKMA) jointly issued a circular that stated the city is prepared to authorize exchange-traded funds (ETFs) with direct exposure to digital assets including spot virtual asset ETFs. This would permit investors to gain exposure to Bitcoin and Ether without directly purchasing cryptocurrency tokens (HKMA, December 22, 2023). These ETFs are expected to help cryptocurrency become more popular among retail investors. When the spot Bitcoin and Ether ETFs debuted in Hong Kong in late April, the city became the first jurisdiction in Asia to allow retail investors to trade these digital assets at spot prices (EastMoney.com, April 25).

Another important regulatory move came in February when the HKMA issued guidance for authorized institutions that intend to provide digital asset custody services, enhancing the license regime established in 2023. The guidance has a strong focus on investor protection, which the HKMA sees as essential to the success of the industry in Hong Kong. To that end, the guidance mandates that authorized digital asset custodians carry out independent systems audits, store a substantial part of their client’s digital assets in “cold storage” offline, and perform a full risk assessment (HKMA, February 20).

The guidance appears to have incorporated some lessons learned from the large cryptocurrency scandals of recent years, including the collapse of FTX, South Korea’s Terra stablecoin and associated reserve cryptocurrency LUNA, and the Singapore-based crypto hedge fund Three Arrows. For instance, it mandates that providers of custodial services separate their assets from those of clients and explicitly forbids misuse of client assets (HKMA, February 20).

Hong Kong is also moving ahead with plans to implement legislation for virtual asset over-the-counter (OTC) services. In a February 21 written statement, Financial Secretary Christopher Hui Ching-yu (許正宇) said that the government plans to submit bills on virtual assets to the Legislative Council “as soon as practicable,” adding that the “government and regulators are committed to enhancing the VA regulatory framework” (CryptoNews CN, February 22).

There is some evidence that Hong Kong’s crypto hub efforts are coming to fruition. According to research firm PitchBook, companies based in Hong Kong and Singapore together received about 11 percent of global venture capital funding for blockchain and cryptocurrency projects through the first 11 months of 2023, up from 2 percent in 2021 (PitchBook, November 30, 2023).

The Limits of One Country, Two Systems

Ever since Hong Kong’s pro-digital assets policy launched in late 2022, there has been speculation that the city would become a pilot zone for the PRC mainland, where cryptocurrency trading and investment are restricted but demand nevertheless remains strong (China Brief, March 29). PRC-born Grenadian cryptocurrency entrepreneur Justin Sun (孙宇晨) has been one of the leading proponents of this viewpoint. In a December 2022 interview that preceded the relocation of his exchange Huobi to Hong Kong, he said that “right now they [the PRC central government] are using Hong Kong as an experiment base so they can see all the feedback, all the results, once they adopt crypto.” He added that he was “super bullish” about the city’s digital assets initiative (Bloomberg, December 20, 2022).

Beijing’s views on decentralized virtual currencies—not blockchain technology, which it broadly views as beneficial—remain ambivalent at best. If the central government observes serious crypto crime occurring in Hong Kong, it could withdraw its support for the territory’s digital assets initiative. Beijing has never issued any statement in support of Hong Kong serving as a cryptocurrency experimental zone for the mainland, however, and has generally avoided commenting publicly about the city’s digital assets policy. According to Hong Kong’s South China Morning Post (SCMP) newspaper, the SFC sent a notice directly to cryptocurrency exchange license applicants informing them that they must “comply with all applicable laws and regulations, including … preventing mainland Chinese residents from accessing any of their virtual asset-related services.” Industry insiders speculated that the message that the mainland market is off limits to exchanges operating in the city has “dampened enthusiasm for operating in Hong Kong” (SCMP, May 29).

That Hong Kong regulators are drawing a line in the sand when it comes to serving mainland investors highlights the limitations of the territory’s One Country, Two Systems governance model and belies the notion that Hong Kong might be a stepping stone for the larger mainland market. The “high degree of autonomy” guaranteed by One Country, Two Systems allows Hong Kong to have a market economy and open financial system different from the mainland’s. Convergence of the two financial systems has never been part of the picture. Investors would do well to listen to what Hong Kong financial regulators say, rather than to crypto influencers. During a panel discussion in late 2022, SFC director of licensing and head of fintech Elizabeth Wong emphasized that One Country, Two Systems “forms the basic foundation to Hong Kong’s financial markets.” The city’s ability to introduce legislation of its own to regulate cryptocurrencies “shows just how separate Hong Kong is from the mainland,” she said (SCMP, October 22, 2022).

Conclusion

In just two and a half years’ time, Hong Kong has steadily developed its credentials as a digital assets hub, implementing an increasingly comprehensive regulatory framework while attracting a large number of cryptocurrency exchanges to establish their operations. The persistence of Hong Kong’s efforts despite the inherent volatility of cryptocurrency and its association with illicit activities reflects the city’s determination to rejuvenate itself as an international financial center. While Hong Kong officials deny any erosion of that status, the departure of expatriate talent and the ascendancy of Singapore suggest otherwise.

Looking ahead, Hong Kong could face growing headwinds in its quest to build a cryptocurrency hub. Friction caused by high demand for cryptocurrency in the mainland and the city’s growth as an industry hub—but not one that can serve mainland customers—could intensify. Hong Kong officials are unlikely to persuade Beijing to change course, which could cause frustration in the digital assets community. Exchanges that had seen Hong Kong as a base from which to serve the much larger mainland market could turn their attention elsewhere. It would be in Hong Kong’s interest to invest greater resources in compliance, as well as step up collaboration among industry, regulators, and law enforcement, to increase the chances of its challenging digital assets initiative ultimately succeeding.