Hong Kong Retail Virtual Asset Funds

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Hong Kong Retail Virtual Asset Funds

Hong Kong Retail Virtual Asset Funds

June 27, 2024

Introduction

After the Securities and Futures Commission (SFC) issued the Circular on SFC-authorised Funds with Exposure to Virtual Assets^¹ on 22 December 2023 (VA Circular), stating that it would "consider authorising investment funds with exposure to virtual assets (VA) of more than 10% of their net asset value (NAV) for public offerings in Hong Kong" (VA Funds) (including but not limited to VA-related exchange-traded funds (VA ETFs)), six SFC-authorised spot VA ETFs were listed on the Hong Kong Stock Exchange (HKEx) for trading on 30 April 2024, being the first batch of spot VA ETFs that are available for trading across the exchanges in Asia.

Background

In December 2017, Bitcoin soared to its then all-time high of US$19,650. However, within just a year, its value plummeted by nearly 80%, trading at less than US$4,000. Noting the risks associated with VAs, but at the same time recognising investors' interest, the SFC was on a mission to formulate a balanced regulatory approach.

On 31 October 2022, the SFC issued the Circular on Virtual Asset Futures Exchange-Traded Funds (VA Futures ETFs), setting out the requirements for VA Futures ETFs seeking SFC authorisation for public offering in Hong Kong. On 1 June 2023, the new licensing regime for Virtual Asset Trading Platforms (VATPs) took effect. The object of the new licensing regime is to fill in the regulatory lacuna in the regulation of crypto trading. With the introduction of the new VATPs licensing regime, VATPs engaging in the trading of non-security tokens are regulated under the VATP regime, while those in the trading of security tokens remain regulated under the SFO.^²

The latest development in this regard was the listing of Asia's first six spot VA ETFs on the HKEx on 30 April 2024. Unlike VA Futures ETFs which "roll" bitcoin and ether futures contracts traded on recognised exchanges, spot VA ETFs provide investors more direct exposure to VAs.

Table summary of the VA ETFs listed on the HKEx

Name of VA ETFs	HKEx code	Underlying assets	Listing date
Bosera HashKey Bitcoin ETF	03008 09008(USD)	Spot bitcoin	30 April 2024
ChinaAMC Bitcoin ETF	03042 83042(RMB) 09042(USD)	Spot bitcoin	30 April 2024
Harvest Bitcoin Spot ETF	03439 09439(USD)	Spot bitcoin	30 April 2024
Bosera HashKey Ether ETF	03009 09009(USD)	Spot ether	30 April 2024
ChinaAMC Ether ETF	03046 83046(RMB) 09046(USD))	Spot ether	30 April 2024
Harvest Ether Spot ETF	03179 09179(USD)	Spot ether	30 April 2024
Samsung Bitcoin Futures Active ETF	03135	Bitcoin futures	13 January 2023
CSOP Bitcoin Futures ETF	03066	Bitcoin futures	16 December 2022
CSOP Ether Futures ETF	03068	Ether futures	16 December 2022

Note: Each of the first six spot VA ETFs was established in corporate form as a sub-fund under the umbrella of an open-ended fund company in Hong Kong with variable capital, limited liability and segregated liability between sub-funds.

Requirements under the VA Circular

In addition to the requirements in: (i) the Overarching Principles Section and the Code on Unit Trusts and Mutual Funds (UT Code) in the SFC Handbook for Unit Trusts and Mutual Funds, Investment-Linked Assurance Schemes and Unlisted Structured Investment Products; and (ii) the joint circular on intermediaries' virtual asset-related activities^³, an applicant must also satisfy the requirements set out in the VA Circular.

The VA Circular sets out the requirements which the SFC will consider when authorising VA Funds, principally from an investor protection perspective on the competence, availability and readiness of the service providers to deliver quality VA-related investment, custodian, administrative and other services. See the following table for a summary:

Area	Description
Management companies	The management companies of SFC-authorised VA Funds should have a good regulatory compliance track record and at least one competent staff member experienced in managing VA or VA-related products. The management companies of SFC-authorised VA Funds are subject to additional terms and conditions to be imposed by the Licensing Department (where applicable).
Service providers	The management companies should confirm that all necessary service providers (such as fund administrators, participating dealers (PDs), market makers and index providers) are competent, available and ready to support the SFC-authorised VA Funds.
Eligible underlying VA	SFC-authorised VA Funds should only invest (directly or indirectly) in VA tokens that are accessible to the Hong Kong public for trading on SFC-licensed VATPs.
Valuation	For the valuation of spot VA, the management companies of VA Funds should adopt an indexing approach based on VA trade volume across major VA trading platforms (i.e. a benchmark index published by a reputable provider that reflects a significant share of trading activities in the underlying spot VA).
Investment strategy	SFC-authorised VA Funds may invest in eligible VA tokens, VA futures (only those traded on conventional regulated futures exchanges) and other exchange-traded VA Funds (subject to requirements imposed by the SFC). It is important to note that SFC-authorised VA Funds should not have leveraged exposure to VA at the fund level.
Transactions and direct acquisitions of spot VA	Transactions and acquisitions of spot VA should be conducted through SFC-licensed VATPs or financial institutions (AIs) authorised by the Hong Kong Monetary Authority (HKMA). For in-cash subscriptions and redemptions, SFC-authorised spot VA ETFs are expected to acquire and dispose of spot VA through SFC-licensed VATPs (either on-platform or off-platform). For in-kind subscriptions, PDs are expected to transfer spot VA, which may be held locally or overseas, to SFC-authorised spot VA ETF's custody accounts with SFC-licensed VATPs, or AIs (or subsidiaries of locally incorporated AIs). The process is vice versa for in-kind redemptions. Both in-kind and in-cash subscription and redemption are allowed for SFC-authorised spot VA ETFs. For VA ETFs that invest in spot VA, their PDs should be: (i) SFC-licensed corporations or registered institutions; and (ii) subject to additional terms and conditions to be imposed by the Licensing Department (where applicable).
Custody	The trustee/custodian of an SFC-authorised VA Fund should only delegate its VA custody function (where applicable) to: (i) an SFC-licensed VATP; or (ii) an AI (or subsidiary of a locally incorporated AI) which meets the expected standards of VA custody issued by the HKMA from time to time. The trustee/custodian must ensure that: (i) VA holdings are segregated from its own assets and the assets it holds for its other clients; (ii) VA holdings are mostly stored in the cold wallet with minimised storage in the hot wallet; and (iii) the seeds and private keys are stored in accordance with a safe protocol. In respect of the storage ratio between cold and hot wallet, it is worth noting that the six SFC-authorised spot VA funds have no less than 98% of their VA holdings stored in the cold wallet.
Risk management	Management companies of VA Funds must monitor and mitigate the risks associated with their investments. Some notable risks associated with spot VAs include: Liquidity risk and trading limit risk: As VATPs are still in early development stages, there may not be sufficient liquidity or there may be a trading limit imposed. Redemptions risk: If significant redemptions of shares are requested, it may not be possible to liquidate the relevant sub-fund& investments at the time such redemptions are requested, or it may be able to do so only at prices below the true market value of such investments, resulting in an adverse effect on the return to investors. Execution risk: The executable price of bitcoin on the VATP may not be the same as the traded prices of bitcoin for valuation. As such, under different circumstances, this may impact PDs'; and market makers' ability to conduct effective arbitrage and provide liquidity for the sub-fund, which may lead to a higher premium or discount to the Net Asset Value and/or a higher bid-ask spread of the sub-fund in the secondary market.

Overall, Hong Kong's updated regulatory approach on virtual assets is welcomed as it supports product innovation. Under the VA Circular, SFC-authorised VA Funds are required to disclose in the offering documents the investment limits and key risks associated with the funds' VA exposures, while management companies of SFC-authorised VA Funds are also expected to conduct investor education before the launch in accordance with the UT Code requirements.

Please contact us if you are interested in discussing any related opportunities.

Acknowledgements to corporate trainee Jacky Cheung for research and contribution to this article.