Original Title: "Hong Kong Announces Opening of Bitcoin Spot ETF - Understanding the Key Points"

Original Author: MetaLab William

On December 22, 2023, the Hong Kong Securities and Futures Commission issued a joint circular on "Virtual Asset-Related Activities of Intermediaries" (hereinafter referred to as the "Joint Circular") and a 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 recognition of virtual asset spot ETFs". What regulatory requirements need to be met for the issuance of Bitcoin spot ETFs in Hong Kong? What impact will it bring in the future? This article will provide a detailed analysis.

1. Interpretation of the Conditions for the Issuance of Virtual Asset Spot ETF

Overall, the issuance of the product needs to meet the requirements of three regulatory documents, namely "Hong Kong Unit Trusts and Mutual Funds Code + 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, ETFs have also been issued through open-ended fund companies (OFCs), but we will not go into detail here. Regarding the "Joint Circular", it mainly introduces the regulatory requirements for virtual asset distribution, trading, asset management, and advisory, which covers a wide range, so we will only introduce the policy part related to BTC spot ETFs. As for the "Fund Circular", it clearly stipulates that the regulatory scope is (1) public issuance and (2) funds that invest 10% or more of the total asset value in virtual currencies, including Bitcoin spot ETFs, so we will focus on this part.

From a detailed perspective, the issuance requirements are as follows:

1. Issuer Qualifications

Different from the US SEC's lack of clear regulations on the qualifications of issuers of Bitcoin spot ETFs, the Hong Kong SFC has imposed stricter regulatory requirements on issuers. Asset management companies issuing virtual asset fund products must meet the following three conditions:

Has a good regulatory compliance record. This means that asset management companies with a bad record are basically excluded, while newly established asset management companies face some uncertainty. Therefore, old-school asset management companies in Hong Kong have certain advantages in issuing BTC spot ETFs.

At least one competent employee with experience in managing virtual assets and related products is required in the company.

The company needs to hold an upgraded No. 9 license. That is, the issuing company needs to comply with the "Terms and Conditions for Licensed Issuing Teams for Managing Investment in Virtual Assets", and it should be noted that this document was revised in October 2023, reducing the application requirements and difficulty.

2. Asset Requirements

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

3. Investment Strategy

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

4. Redemption and Trading of Spot Virtual Assets

Currently, virtual asset spot ETFs are being issued in Hong Kong, allowing for two modes of operation: cash (Cash Model) and in-kind (In-Kind Model). The main reason for this is that there are currently no specific regulations governing virtual asset trading platforms in the United States. If in-kind subscriptions and redemptions are accepted, criminals may use BTC to directly purchase ETFs to launder money. However, in Hong Kong, licensed exchanges are required to comply with the Anti-Money Laundering Ordinance, and coin deposits and withdrawals must undergo strict KYC/AML audits. Therefore, using licensed exchanges for in-kind subscriptions and redemptions can effectively avoid the problems faced by the US market, but this also adds additional requirements for the Hong Kong market:

· Cash subscription and redemption requests must be made through licensed exchanges in Hong Kong, but can be conducted on-platform or off-platform.

· The redemption and subscription of physical assets require the virtual assets to be transferred to a licensed exchange or Authorized Financial Institutions (AIs) and their affiliates recognized by HKMA in Hong Kong first.

· The trader (PD) participating in the redemption needs to hold the upgraded No.1 card.

5. Hosting

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

· The custodial account must be separated from the asset management company's own account;

· Most of the assets are stored in cold wallets, and a small portion is stored in hot wallets for redemption purposes.

· Private key security management requires that the private key must be stored in Hong Kong to effectively prevent external attacks and ensure proper backup.

6. Valuation

Regarding valuation, SFC has shown a lenient side. The index used for valuation calculation does not require inclusion of only licensed exchanges in Hong Kong, but can also include major overseas exchanges. There are no special restrictions on index providers, only a requirement for good reputation.

7. Risk Disclosure and Investor Education

This section is covered in both the "Joint Circular" and the "Fund Circular". The "Fund Circular" mainly covers risk disclosure in issuance documents and financial reports, while the "Joint Circular" mainly focuses on risk disclosure requirements in the distribution process. Of course, both circulars require issuers and distributors to provide investor education.

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