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China Casts Long Shadow Over Hong Kong's Once-Vibrant Crypto Industry

Hong Kong Fintech Week was once a buzzing melange of entrepreneurs in T-shirts with bankers and bureaucrats in suits, all discussing cryptocurrency’s role in the future of money.

Last year’s gathering, held in November, was markedly different. Government officials emphasized the potential of greater integration with China and its digital yuan, while conversations about crypto focused on what is deemed appropriate on the mainland.

The contrast points to a larger shift.

As China has tightened its grip on Hong Kong, the city’s digital assets industry has grown uneasy and chastened. Many firms have left Hong Kong or downsized operations. Local regulators were mostly inactive last year, only adding to the uncertainty.

Hong Kong has been an epicenter of crypto throughout the asset class’s development, thanks to one of the world’s strongest finance ecosystems, a vibrant entrepreneurial spirit and proximity to, well, China. (The mainland was once a hotbed of trading and mining activity before a series of crackdowns by Beijing, most recently in September.) Iconic firms, such as exchanges FTX and BitMEX, VC Kenetic Capital and EOS developer, have their roots in the city.

Now, most of the remaining firms in Hong Kong have backup plans.

"They still have a big presence in Hong Kong,” but they're looking at different options for their operations, said Vivien Khoo, co-founder of the Asia Crypto Alliance, a trade association based in Singapore.

Many Hong Kong firms are having “active discussions," particularly in light of COVID-19, "about what it means to be working remotely because that can give them flexibility,” she added.

There are glints of hope. One month into 2022, the Hong Kong Monetary Authority (HKMA) – the city’s equivalent of a central bank – has issued two key papers: one on stablecoins and another on crypto-related exchange-traded funds.

Hong Kong “is beginning to establish the regulatory framework for digital assets that is consistent with its status as a global hub for financial services and wealth management,” said Lennix Lai, director of crypto exchange OKX. “With clarity on the parameters in which the market can operate, investors will no longer be held back by fears over a regulatory backlash.”

Yet while the city’s future in the global crypto ecosystem is starting to take shape, it looks a lot more limited than its freewheeling past. Several industry participants told CoinDesk it was likely that Hong Kong’s regulatory regime would remain stable in the short to medium term but agreed that the long-term prospects were likely bleak.

The China connection

Four of the people who spoke to CoinDesk for this article requested anonymity because they were not authorized to speak publicly on what their firms deem a politically sensitive topic. Three of those work for crypto financial services firms, while a fourth is a stock analyst.

“It’s hard to expect that you are not allowed to do any crypto in the mainland, but Hong Kong is [going to remain] a paradise” for the industry, quipped one local participant.

As a special administrative region under the “one country, two systems” principle, Hong Kong is territorially a part of China but sets its own laws and regulations.

On paper, Hong Kong’s relative autonomy from the mainland is set to expire in 2047, although many observers, including the U.S. State Department, have noted that China’s central government is already chipping away at Hong Kong’s freedom.

The National Security Law that came into force on June 30, 2020, criminalized broadly defined acts of sedition, collusion, terrorism and subversion and granted authorities extensive powers of surveillance, detention and search. As of June, 117 people had been arrested under the law; most of them were politicians, activists and journalists, and the list also included media tycoon Jimmy Lai, owner of popular pro-democracy tabloid Apple Daily.

The political risk related to crypto in Hong Kong dates before China’s 2021 crackdown, said Alessio Quaglini, co-founder and CEO of crypto custodian Hex Trust. Hex started looking into a Singapore office “since day one,” which the firm sees as a “backup plan,” he said.

The custodian has since acquired a Capital Markets Services license in Singapore and is waiting for a crypto license, he said.

Year of no light

The feeling on the ground got grimmer last year. There was little news from Hong Kong regulators, and what was announced made firms wary.

On May 21, 2021, Hong Kong authorities proposed fines up to $640,000 and seven years imprisonment for unlicensed exchange activity. Compounding this was the mainland’s increasing influence on the city and its staunch anti-crypto stance.

Around mid-2021, the market’s perception was that regulators felt that “If you’re not licensed, we want you out of Hong Kong, fast,” particularly in light of the potential for fines and imprisonment, said Khoo.

On Sept. 24, 10 of China’s top national finance and tech government institutions declared all crypto-related transactions illegal. While this was not the first time China has restricted crypto, it was the first time several of the country’s top agencies issued a comprehensive action plan that left little room for interpretation.

Following the announcement, the sentiment on the future of crypto in Hong Kong soured, one analyst in the city told CoinDesk, adding that their company has since forbidden them from publicly discussing crypto.

After the mainland tightened its policy, Hong Kong’s biggest retail-focused licensed trading platforms that offered crypto funds, Futu and Tiger Brokers, said they will stop users from buying crypto products on their platforms starting Oct. 1.

A Futu representative told CoinDesk the move was “in response to relevant regulatory guidelines” but didn’t clarify whether they were referring to China’s guidelines. Tiger Brokers did not respond to CoinDesk’s request for comment.

‘Nice place to hang out’

For the time being, Hong Kong is under an opt-in licensing regime for crypto firms. To obtain these optional licenses, firms have to follow the Financial Services and Treasury Bureau (FSTB) recommendations.

The only license for automated trading, which is necessary for operating a crypto exchange, has been granted to OSL Digital Securities. None have been granted since OSL received its license in December 2020.

While there’s a lot of talk about China’s influence in Hong Kong, “At least for now, crypto regulations are decided by the Securities and Futures Commission (SFC),” said Henri Arslanian, leader of the crypto practice at consulting giant PwC.

The SFC has expressed that it is not a fan of crypto derivatives. FTX, one of the world’s largest trading platforms for digital asset futures, moved its headquarters from Hong Kong to the Bahamas the day after China announced its crackdown. FTX founder and CEO Sam Bankman-Fried said at the time it wasn’t in response to “recent news.”

COVID-19 restrictions – which have only intensified in the past few months – make it hard to hire in the city, “So, there is already some movement away from Hong Kong,” said Leonhard Weese, president of the Blockchain Association of Hong Kong.

Serving overseas customers out of Hong Kong is a cushy option, Weese said. All the big players already act under the assumption that “Hong Kong is a nice place to hang out in, they’re not interested in selling their products to the Hong Kong market because it’s too small and complicated,” he said. So, even if authorities cut their access to the local market, it won’t be a big problem, Weese said.

Instead, these companies want to serve the world, and there is little indication that might not be acceptable to the regulators in the future, he said. Even if things change, they can easily pick up and leave.

New licensing requirements in Hong Kong

The Hong Kong government had announced plans to propose an anti-money laundering bill in the 2021-2022 legislative session that is based on a consultation paper drafted by the FSTB in November 2020. The bill’s licensing regime for crypto exchanges is envisioned as a barrier against money laundering, and, unlike the current one, it would be mandatory.

In response to a CoinDesk inquiry on whether the crackdown on the mainland will affect rules in Hong Kong, the FSTB reiterated its position that virtual assets are not legal tender and pointed to the territory’s existing regime.

The SFC did not respond to CoinDesk’s request for comment while the HKMA referred the inquiry to the other two agencies.

The November FSTB paper recommended requiring licenses for virtual asset service providers, including crypto exchanges, and limiting their services to professional investors, among other measures.

Hong Kong law defines professional investors as individuals or corporations who have a portfolio worth upwards of HK$8 million ($1 million) or companies with more than HK$40 million ($5 million) in assets.

Still, with a full draft of the bill yet to be publicly available or discussed in Hong Kong's Legislative Council, many crucial details are hanging in the balance.

The scope of the licensing regime is not totally clear, said Weese. It is unclear if smaller over-the-counter (OTC) exchanges and bitcoin ATMs will be allowed, or what kind of risk is going to be put on individuals that just trade OTC with their friends, he said.

For many exchanges, getting a license will mean that “Their entire systems and products are going to be massively crippled” because they can only offer spot trading and only serve institutional investors, Weese said.

Many firms are preparing to “fly under the radar” to avoid regulatory attention while figuring out how to change their business model such that they can go global, reach new user bases or somehow avoid falling under the licensing regime, he said.

One person who works for a Hong Kong-licensed crypto firm described the unlicensed companies as living “on another planet,” in that their behavior and attitude toward regulations is completely different from those of licensed firms.

Big-picture worries

Given the mainland’s draconian policy on digital assets, Hong Kong’s dwindling independence is reason for concern for the local crypto community.

“The Chinese government is taking over and slowly changing the system,” and it is only a matter of time before it trickles down to crypto, another source in Hong Kong’s crypto industry said.

In the last two years or so, people in Hong Kong have lost confidence in the fact that its legal system is completely separate from mainland China’s, and they are more likely to bite their tongues when talking about crypto, Weese said.

Generally speaking, bitcoin conversations often devolve into political discussions about freedom and the limits of the government, which is increasingly a taboo topic, Weese said. If you try to come up with real-world examples, you might get into all sorts of issues that are highly controversial in a city where the government has seized funds from civil rights organizations.

Aside from regulatory backlash, Hong Kong firms are closely tied to China, so a dwindling crypto industry in China does not bode well for Hong Kong’s ecosystem.

The crackdown has been a problem for Hong Kong asset managers who have clients in the mainland, the analyst said, because communication is now considered risky.

At the same time, many Hong Kong firms have research and development or back offices in China, Arslanian pointed out.

“If you want to be a financial center, tech talent is important,” said Arslanian, adding that Singaporean companies often outsource tech development to India, and Hong Kong crypto firms usually work with Chinese engineers.

But China’s latest policy targets tech talent working for overseas exchanges in China as well.

The question for these connections will be where Chinese regulators draw the line, Arslanian said, and whether foreign exchanges that don’t serve Chinese clients will be allowed to do research and development in China.

The future of crypto in Hong Kong

Peer-to-peer crypto trading will likely remain vibrant in Hong Kong because it is very difficult to stop and allows for quicker transactions in a cash-based society, Weese said. These trades could be increasingly scrutinized by authorities looking for money laundering, such that large transactions will draw attention, the association head said.

But what will happen to virtual asset service providers (VASPs) is unclear.

Khoo and her co-founder, Su Yen Chia, view the HKMA’s papers as encouraging developments.

“At least now people know that the regulator is looking into it, providing some direction, [...] and they're asking for comments and feedback from the industry,” Chia said.

The paper also firmly distinguishes HKMA’s views from mainland policy. "On paper, they are looking at stablecoins as a payment tool," she said, in contrast to the mainland where no crypto can be used in commerce. For crypto assets not related to payments, HKMA is “looking at how it develops hence, they are not stymying innovation,” Chia added.

The city’s regulators are keen to keep their competitive edge vis-a-vis markets like Singapore, Khoo said.

The proposed regulatory framework for digital assets in Hong Kong fits within Beijing’s wider framework for crypto, Omer Ozden, CEO of Beijing and New York-based venture capital firm RockTree Capital, told CoinDesk. The mainland government wants to avoid systemic financial risk.

The “blue sky” scenario is that the rules proposed by the FSTB, already some of the world's most stringent, are the ones that remain in place in the medium term, said the analyst.

If new rules come, licensed firms will be the winners, and unlicensed ones will face increasing regulatory pressure, the analyst said.

The exchanges that are still based in Hong Kong are going to move operations “silently but consistently” away from the city, Weese said.

“Regulatory clarity is always welcome as it legitimizes the asset class,” Esme Pau, head of emerging technology at stock brokerage China Tonghai Securities. But whether Hong Kong’s stockbrokers can offer digital asset-related products remains an open question, she said.

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