Hong Kong SFC to proceed with retail crypto ETF authorisation plan

Hong Kong's regulator sees scope for opening up a maturing crypto market to retail investors, but questions remain about whether investors are sufficiently protected.

A version of this story was first published by AsianInvestor.

Hong Kong’s financial regulator is pressing ahead with its plan to open the market for cryptocurrency futures funds to retail investors.

A spokesperson for the Securities and Futures Commission (SFC) told FinanceAsia sister publication, AsianInvestor, that the regulator is satisfied with its recently introduced rules for crypto fund approval and believes they are sufficient to safeguard investors from substantial losses, despite the bloodbath seen in the wake of the recent FTX scandal.

The FTX cryptocurrency exchange, valued at $32 billion earlier this year, has entered bankruptcy proceedings as its founder and former CEO, Sam Bankman-Fried, remains embroiled in a misuse-of-funds scandal. The collapse of the exchange carries wide-ranging effects for investors, including Singapore’s Temasek, which has written off its $275 million investment in FTX.   

There can be little doubt that cryptocurrencies are still very much a speculative asset. Investors in Grayscale Bitcoin Trust, the world’s largest cryptocurrency fund, have seen its NAV decline by 83% since bitcoin peaked in November 2021.

Contagion is the biggest unknown risk for investors in this market. Grayscale also suffered knock-on effects from the failure of Three Arrows Capital, a Singapore-registered crypto hedge fund that filed for bankruptcy in July.

Hong Kong-based fund industry veteran and former senior advisor at Citigroup Stewart Aldcroft told AsianInvestor it was right to question whether retail investors should be able to buy into crypto products such as ETFs.

Retail risks

“I suppose any regulatory approval, such as by the SFC, would require retail products to come with detailed health warnings and possibly higher minimum subscription levels. But then again, investors will always find a way when they want to buy something, and crypto has that effect on many,” Aldcroft said.

One risk is that investors could erroneously believe that by investing indirectly, via crypto futures, they would be protected from the market’s extreme fluctuations. Data from the US showed investors put a net $379 million into crypto funds in 2022, despite numerous scandals that have befallen firms in the industry.

Aldcroft believes younger investors are the most at risk, as they may more “willingly experiment with where they put their money, and based on the theory that many more traditional investment areas have not done so well in recent years."

The G20’s Financial Stability Board has said “the recent turmoil in crypto-asset markets highlights their intrinsic volatility, structural vulnerabilities and increasing interconnectedness with the traditional financial system.

“An effective regulatory framework must ensure that crypto-asset activities posing risks similar to traditional financial activities are subject to the same regulatory outcomes, while taking account of the novel features of crypto-assets and harnessing their benefits.”

The SFC’s current position on regulating crypto funds was set out by deputy chief executive officer Julia Leung during Hong Kong Fintech Week in October. In her remarks, she said, “the excesses of certain crypto firms threaten not just their own well-being, but also that of investors and the entire crypto ecosystem.”

Exponential increase

When the SFC first introduced its regulatory framework for virtual assets (VA) in 2018, the crypto market was still relatively new, and access was restricted to professional investors.

“Four years have now passed,” said Leung, “and while crypto assets remain volatile, their global market capitalisation has increased exponentially. From our own product survey, we note that investors bought HK$10 billion in VA funds via overseas platforms in 2021, up from HK$8 million a year earlier. Investors now have a better understanding of the risks of trading these assets.”

Reflecting this perceived sophistication amongst investors, the SFC had been actively looking to set up a regime to authorise ETFs which could provide exposure to mainstream virtual assets along with the appropriate investor guardrails. Leung disclosed that virtual asset futures ETFs would be subject to additional requirements related to its management company, investment strategy, disclosure and investor education

A fund management company offering a VA futures ETF, for example, would be expected to adopt an active investment strategy to allow flexibility in portfolio composition, including a diverse array of futures positions with multiple expiry dates. The net derivative exposure of such an ETF should not exceed 100% of the ETF’s total net asset value, according to the regulator.

Product disclosures should contain upfront information about key risks associated with VA futures such as margin risk and risk associated with mandatory measures imposed by relevant parties. 

In the initial stage, the SFC expects underlying assets to be confined to Bitcoin futures and Ether futures traded on the Chicago Mercantile Exchange.

An earlier SFC circular does acknowledge that “a good part of the VA ecosystem (for example, VA trading platforms) is still not subject to the same robust regulation as service providers or products in traditional financial markets,” and thus “investment products that invest directly in spot VAs may continue to present investor protection issues.”

Following this month’s crypto market ructions, Hong Kong’s regulator appears not to have ruled out strengthening regulations. “The SFC may consider introducing additional requirements or conditions as deemed necessary or appropriate in the discharge of its functions,” a spokesperson told AsianInvestor.

The spokesperson was unable to comment on any crypto ETF applications so far received for authorisation.

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