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Taking forward the virtual asset industry development in Hong Kong steadily and prudently

The HKSAR Government issued a policy statement on the development of virtual assets (VA) in Hong Kong at the end of last month, setting out our vision and policy approach towards the VA sector, relevant innovative technologies and their applications, as well as the development of the VA ecosystem. We seek to create a suitable environment for the growth of the industry through policies facilitating innovation, a comprehensive and balanced regulatory framework and a "risk-based" regulatory approach. We also pragmatically propose a number of pilot schemes to test and enhance the level of technology and their applicability.

This policy statement demonstrates our determination and commitment to explore financial innovation with the industry and clearly states our position: in actively embracing innovation, there must be corresponding and up-to-date regulation to manage the risks properly and create the prerequisites for an orderly and prosperous market. The policy statement has received recognition and support from the industry in general. We have also received a lot of positive responses, and many enterprises in the sector are considering to expand their operations in Hong Kong or relocate their business back to Hong Kong.

Since the middle of this year, we have seen a number of crypto breakdown and bankruptcy of the relevant companies. A major cryptocurrency trading platform also filed for bankruptcy protection last week. The market has described the period as a "Crypto Winter". This has helped reinforce the industry's belief that a VA service provider must operate in a transparent manner and be subject to proper regulatory and compliance requirements, particularly in the areas of corporate governance, financial and operational disclosure, and investor and user protection. All these are conducive to the long-term development of the VA industry; this is also the international consensus. The policy statement we issued has laid a foundation for cultivating such environment, and has kindled the industry's good hopes for the development of the VA market in Hong Kong.

Whenever VAs are mentioned, cryptocurrencies and speculation always come to mind. In fact, virtual or digital assets involve a wide range of innovative technologies, including:

1. "Fungible tokens", such as Bitcoin and Ethereum, are a type of virtual asset which is characterised in the sense that each token has the same value and function, and may be divided into smaller units for trading. This characteristic allows the trading of such token to be free from restrictions arising from geography, system, registration or time. The total market capitalisation of the cryptocurrencies market, which had once been exuberant over the past few years, was estimated to have once reached nearly US$3 trillion.

2. "Non-fungible tokens" (NFT) are neither divisible nor replaceable (i.e. having a unique digital identity) and allow digital objects to be transferred by placing specific information, such as digital images, videos or clips, onto a blockchain in an encrypted form. Many native assets originating from the chain are exchanged in the form of NFTs. This function of tokenisation can be linked as 'tokens' of traditional financial instruments for more convenient and efficient transaction, and may even be used as smart contracts in commercial transactions.

Whether fungible or not, that the 'token' is able to exist in a unique and digital form that cannot be copied, is based on the Distributed Ledger Technology (DLT), which records information over time in blocks and stores copies over the Internet, making it difficult for records, such as digital tags and transaction history, to be tampered with or deleted.

Despite having a unique digital tag and an open and transparent record of transactions, the transaction details are encrypted, providing sufficient information security. In other words, the encryption under blockchain technology provides information security; distributed ledger avoids tampering with transaction records and provides efficient, secure, transparent and cost-effective transaction conditions without the need for central registration formalities. As such, many financial institutions are exploring ways to have their financial assets tokenised to address the difficulties in clearing, settlement and payment that have persisted for the years.

Analyses have pointed out that the application of blockchain has created a decentralised web world, or the so-called web 3.0, which is the underlying technology driving the Metaverse, allowing institutions and individuals to use the token function of NFT to conduct direct peer-to-peer transactions. How this feature can be applied to different financial services, business transactions and even corporate services is still under exploration, but there is a consensus among the industry that huge potential does exist for application development.

In our policy statement on VA development, we have proposed several pilot projects, including the tokenised offering of a new tranche of green bonds for institutional investors, which is expected to be launched within the year and will be the first tokenised government green bonds in the world. The Hong Kong Monetary Authority (HKMA) is also studying e-HKD, which may serve as the "backbone", linking flat currencies with VA, and facilitate more innovations in the space. In addition, the HKMA has earlier conducted a consultation to explore the regulation of payment-related stablecoins and will announce the next steps in due course.

The Securities and Futures Commission (SFC) has also embraced innovation while upholding the principle investor protection, and has been closely monitoring the technological innovations, changes in applications and the regulation required in relation to VA. Under the regulatory principle of "same business, same risks, same rules", the SFC has licensed two VA trading platforms with regulatory requirements similar to those of traditional stock exchanges, including the requirement to keep client assets in segregated accounts, to comply with financial resources requirements and to maintain at least 12 months of actual operating expenses, and to avoid conflict of interest (no participation in proprietary market-making activities). The SFC has also licensed eight VA fund managers and approved two brokers to provide VA dealing services for their clients under an omnibus account arrangement. We have recently been working to introduce a licensing regime for VA service providers so that such operators will be subject to regulatory requirements similar to those of traditional financial institutions, including compliance with the anti-money laundering and counter-terrorist financing and investor protection requirements. The policy statement also sets out that the SFC will be conducting a public consultation on how retail investors may be given a limited degree of access to virtual assets under the new licensing regime. The Government welcomes the possibility of introducing virtual asset futures exchange traded funds (ETFs) in Hong Kong.

Past waves of technological innovation have led to leaps and bounds in economic and industry development. Although the process may inevitably have its ups and downs, the long term benefits and inspiration brought to our future generations are worth acknowledging. The tech bubble burst in 2000 has caused many people to be wary of technological development. However, in the environment of mobile terminals and network, technology has evolved on its own path and developed into platform and network economies. While the bubble and volatility in the VA market over the last few years have disturbed the investment market, financial innovation has not ceased to develop and the industry continues to evolve in technology and applications.

The policy statement therefore aims to establish a comprehensive regulatory framework for the VA industry; it actively promotes technological innovation and application while ensuring that risks are appropriately managed. We need to make full use of the potential of innovative technologies, but at the same time guard against the volatility and potential risks they may cause, and the transmission of these risks and impacts to the real economy. The repeated collapse of cryptocurrencies or the filing for bankruptcy protection of the relevant trading platforms once again is a reflection of the need for transparent operations and appropriate regulation. With these in place, we can ensure the long-term stable and sustainable development of this industry.

On the premise of safeguarding safety and appropriate risk management, embracing innovation will certainly bring new strengths to economic and industry development. The realisation of its potential and the innovation of its application require the development of relevant technologies and the entire ecosystem, including cryptocurrencies, VA exchanges, the development of the Metaverse, and innovative application of "tokenization", such as in securities issuance and trade finance. In considering the overall direction of development, a core direction is that if the purpose of the financial world is to serve the real economy, technological innovation should also play the same role in serving the real economy. I hope that our friends in the innovation and technology ecosystem can join hands to promote more efficient, convenient and innovative applications where risks are controllable, bringing more new opportunities to traditional industries and enterprises, so that the innovation and technology industry can make good progress with its own development, and at the same time assist in bringing the whole economy into a new phase of growth.

November 13, 2022