Industry insiders said the city’s new licensing system paves the way for exchanges to operate legally and serve retail customers, but strict compliance requirements could cost companies up to $2000 million.
- Strict applicant requirements and high fees can eliminate smaller companies.
- The platform’s ability to serve retail clients could give institutional investors more confidence to enter the cryptocurrency market.
Cryptocurrency exchanges may have to spend up to $6 million to obtain a license to operate in Hong Kong under a new regulatory regime that took effect in June.
The new licensing regime for virtual asset trading platforms gives exchanges operating in the city one year to apply for new approval or leave.
So far, trading platforms OSL and HashKey, which held licenses under the previous opt-in regime, have received approval under the new regime and can now provide services to retail investors.
However, three people familiar with the application process but not authorized to speak publicly about it told CoinDesk that obtaining a new license could cost between $1200 million and $2000 million.
Their estimates take into account the operational costs of obtaining licenses and payments to the necessary vendors for the app itself, including consultants, lawyers and insurers.
OSL and HashKey are part of larger financial services groups and may have excess capital, but the cost of consideration under the new rules will be prohibitive for many companies.
Licensing consultants can charge up to $100 million to advise companies on their applications, one person familiar with the matter said. Exchanges must maintain paid-in capital of 500 million Hong Kong dollars ($64) and at least $38 in liquid capital. They must hold liquid assets equivalent to at least one year's operating expenses, excluding virtual assets.
Companies must invest in the ability to ensure segregation of customer funds, safe custody of assets, payment of smart contract audit fees and overall corporate governance. Before attracting investors, companies need to assess their understanding of virtual assets.
Companies must also have a local branch and store seed phrases and private keys (with backups) in Hong Kong. They must hire a compliance officer, called a licensed responsible officer (RO), to ensure that the business meets regulatory requirements, and each applicant must have at least two ROs. Due to high demand, ROs usually charge extra for their services.
“We will have a natural selection of players in the market,” Alessio Quaglini, CEO of Hex Trust, which is planning to apply for a Hong Kong license for its exchange, HTX, told CoinDesk.
High Benchmark
The announcement of the licensing regime triggered a rush of applications, but industry members knew not all applications would meet the regulator’s benchmarks.
Will Corkin, co-founder of SOMA.finance, said smaller exchanges that may not have large volumes or a track record of doing things the right way “are going to face a pretty uphill battle” to get licensed.
Zhan Jun, director of risk consulting at KPMG China, noted that despite interest from “quite a few parties”, only eight banks have been granted virtual banking licenses.
Zhan explained that the CSRC has shared its "minimum standards" for applicants. In addition to meeting these requirements, applicants also need to ensure that they "present the strongest case to support their application," Zhan said.
China’s Regulatory Sandbox
While China prohibits its own people from trading virtual assets, Hong Kong residents have an implicit license. Meetings in Hong Kong are starting up again, with attendees flying in from Singapore and Dubai to see if the city is truly open.
“I’m sure it’s not easy,” said Angelina Kwan, CEO of Stratford Finance, referring to Hong Kong’s approval as China’s regulatory sandbox for digital assets. However, Hong Kong serves as a testing ground for other activities banned in mainland China. Hong Kong is home to international capital markets and allows horse racing betting (Chinese citizens cannot invest directly in overseas stocks and gambling is also prohibited).
Meanwhile, the city’s leaders mentioned Web3 in their budget, a Web3 working group was formed, and the government’s promotional arm, InvestHK, appears at nearly every industry event. Local politicians have invited global exchanges to apply for licenses.
The hope is that once platforms start to receive licenses, investors will be able to move fiat currencies from banks to trading platforms, trade in fairly liquid markets, and gain exposure to virtual assets.
“People want to have a regulator like the Securities and Futures Commission behind them,” Corkin told CoinDesk.
“It’s a different story than it was in 2017 when smaller European countries opened up exchanges,” Corkin said.
Holding a license issued by a globally renowned financial regulator means that the licensed platform is more likely to meet the internal standards of the investment company, allowing more capital to enter.
Allowing retail traders to use the platform may also give confidence to institutional investors, as regulators tend to set higher barriers to entry for retail investors.
What is allowed?
The biggest hype is that the regime has allowed platforms to serve retail investors. Retail trading in Hong Kong has always been a gray area, with investors turning to global exchange Binance and buying NFTs on OpenSea (the latter remains unregulated).
But derivatives, the exchange’s biggest money-maker, remain out of the question. The system only allows investors to trade large-cap coins.
Tokens need to be listed in two acceptable indices and undergo due diligence. They need to have a one-year track record. Developer backgrounds, supply, demand, and liquidity will all be checked.
No external custodian
Under the system, platforms cannot choose external custodians. They must handle custody themselves. One of the most stringent requirements for platforms is that they must have insurance or indemnity covering the potential loss of 50% of customer virtual assets in cold storage.
The cost will be borne by loss-making companies or end users who may choose to use offshore exchanges, Quarini said.
In his view, there should be some reputable specialized custodians who can afford the insurance costs. Some professional players mean they can run a profitable business.
“It’s going to be very difficult to develop competitive players,” he said.
Mr. Guan, who used to work at the CSRC, explained that the regulator’s requirement for exchanges to self-custody is a need to know who is responsible. “It’s a chokehold,” said Guan, who also pointed out potential security risks in terms of connectivity.
Surrounding infrastructure
Since cryptocurrency exchanges must have ties to a bank to apply for a license, the Hong Kong Monetary Authority, the city’s de facto central bank, has been hosting roundtables for banks and virtual asset players, the first in April and another in June.
Companies are finding it hard to maintain reliable banking relationships, and some fear that even if they manage to open an account, it may be closed. Consulting firms have been giving presentations to bank compliance teams to let them know the risks to look for.
Finding the right insurance or even provider is also an issue for applicants. Guan said some companies end up mistakenly purchasing physical insurance instead of comprehensive or fiduciary liability insurance.
Like banks, insurance companies are also unsure about using cryptocurrencies.
Follow up
Annie Hui, co-founder of digital asset security firm Custonomy, said she hopes that as the guidelines are refined, proof of solvency will be incorporated into the system, meaning that platforms have mechanisms in place to prove that the total amount of assets under custody is greater than the total amount of liabilities.
As of now, stablecoins are not allowed. Lennix Lai, chief commercial officer at OKX Global, said their inability to be traded for retail purposes is a “temporary arrangement,” adding that he is “cautiously optimistic” that they will be available for use once the HKMA issues its conclusions on stablecoins. Whatever happens, it’s clear that algorithmic stablecoins like the now-defunct terraUSD will not be allowed.