According to a report by The Block on January 1, Harvest Global ETF became the first institution to submit an application for a Bitcoin spot ETF to the Hong Kong Securities and Futures Commission. As early as December 29 last year, the Hong Kong Securities and Futures Commission issued a circular on the approval of funds to invest in virtual assets by the Securities and Futures Commission, clearly stating that it was ready to accept the approval application for a virtual asset spot ETF.
Across the Pacific Ocean in the United States, the development of Bitcoin spot ETF after its approval for listing is of great reference significance to Hong Kong. However, due to Grayscale's continued selling of Bitcoin, the US Bitcoin spot ETF did not bring amazing performance to the market 19 days after its listing. At this time, is it still meaningful for Hong Kong financial companies to enter the Bitcoin spot ETF?
Choose Central or Wall Street: Multiple subscription and redemption methods may be the biggest advantage
Comparing the two places, Hong Kong is better than the United States in some rules for virtual asset ETFs. According to the "Circular on SFC-approved Funds Investing in Virtual Assets", Bitcoin spot ETFs can be subscribed and redeemed in both physical and cash (hereinafter referred to as "subscription and redemption").
Although the U.S. applicants wrote in their early applications that "redemption is allowed in both physical and cash methods," based on risk considerations, they eventually modified their applications to use the less risky "cash" redemption method.Compared with the US Bitcoin spot ETF which is limited to "cash" subscription and redemption methods, according to the circular currently disclosed by the Hong Kong Securities and Futures Commission, it is expected that multiple subscription and redemption methods of cash and physical goods will become the main advantage of Hong Kong's future Bitcoin spot ETF market.
Due to the particularity of Bitcoin virtual assets, adding physical redemption methods brings more challenges in the exchange, custody and transfer of Bitcoin assets.Taking subscription as an example, on the premise of ensuring compliance with local compliance requirements, participating traders should first transfer virtual assets to a custody account approved and licensed by the CSRC, including a virtual asset trading platform (VATP) or an authorized institution (or its subsidiaries). This is mainly to prevent criminals from converting and laundering Bitcoin through physical redemption.
Physical subscription and redemption involve the transfer of on-chain assets, which requires financial institutions and regulators to adopt a different compliance approach from the traditional market - on-chain compliance. On-chain compliance has some similarities with traditional off-chain compliance, including KYC (know your customer), AML (anti-money laundering) and cross-border compliance. In order to achieve these compliance requirements, compliance technology tools are usually required. These tools are mainly used to perform asset risk confirmation of on-chain addresses and continuously monitor asset flows for suspicious transactions.
Due to the particularity of blockchain technology, although transactions on on-chain addresses cannot be tampered with, are clear and transparent, and can be checked by the public, their anonymity makes many institutions feel daunted when complying with regulations. In order to deal with this anonymity, one feasible solution is to compare the address with high-risk addresses marked as sanctions, money laundering, phishing, etc. to determine whether the on-chain address is involved in excessively high-risk transactions. For this reason, having a rich and comprehensive address label library has become one of the important criteria for financial institutions and regulators to choose compliance technology tools.
In terms of continuous monitoring of asset flows, when selecting compliance technology tools, financial institutions should not only select compliance technology tools with large amounts of data and a rich and comprehensive address tag library, but also consider the response speed of compliance technology in continuous risk monitoring. Once compliance technology tools screen out suspicious transactions, such as OKLink, they can monitor risks within milliseconds and quickly perform subsequent operations: determine the risk level and take risk control measures based on the level, such as freezing accounts or refusing transactions.
The figure takes OKLink Onchain AML as an example, a simple diagram of Bitcoin spot ETF from issuance to trading with the help of compliance technology. Note: This is a rough flow chart; in terms of compliance technology requirements, "intermediaries" are required to be supported by compliance technology, which is a more rigorous approach.
What qualifications does the custodian institution need for the physical redemption method?
Hong Kong has approved futures-based Bitcoin ETFs. Currently, there are two listed products, CSOP Bitcoin Futures and Samsung Bitcoin Futures. Their asset scale is relatively small, with each fund's AUM less than US$1 million. The trustees of these two funds are HSBC Institutional Trust Services (Asia) Limited. It is worth mentioning that HSBC is the first bank in Hong Kong to allow customers to buy and sell virtual asset ETFs listed on the Hong Kong Stock Exchange, and it launched the Virtual Asset Investor Education Center in the middle of last year.
Unlike futures ETFs, which only require cash for custody, the difficulty of spot ETF custody is that the custodian needs to be responsible for Bitcoin custody. Currently, according to the SFC's "Circular on SFC-approved Funds Investing in Virtual Assets", the trustee/custodian of a virtual asset fund authorized by the SFC can only entrust the virtual asset custody function to a virtual asset service provider (VATP) holding an SFC license or a financial institution or local subsidiary that meets the virtual asset custody standards issued by the HKMA.
Figure: Excerpt from the Circular on the SFC’s Approval of Funds Investing in Virtual Assets
In other words, judging from the current development of financial institutions and virtual asset service providers (VASPs) in Hong Kong, financial institutions and licensed VATPs will be responsible for the custody of fiat currencies and virtual assets respectively, and the mutual coordination between the two will also be the key to the success of the Bitcoin spot ETF.
The same is true in the United States. Among the 11 ETFs approved so far, 8 ETFs have chosen Coinbase as the custodian of their virtual assets. Taking Grayscale and BlackRock, which currently rank in the top two in terms of AUM, as examples, both parties have chosen Coinbase and Bank of New York Mellon as the virtual asset custodian and cash custodian respectively, adopting the form of separate dual-institution custody of virtual assets and legal currencies.
Figure Grayscale GBTC Basic Information
In terms of VATP, several companies in Hong Kong are currently actively applying for relevant licenses. This indicates that there will be multiple VATPs for fund companies to choose from in the future, thus avoiding the "single point" risk similar to the multiple Bitcoin ETFs in the United States choosing only one custodian.
Grayscale is just an isolated case, Hong Kong will not repeat the same mistake
Since the United States approved the Bitcoin spot ETF, one of the most concerned topics has been Grayscale's continuous huge sell-offs. However, there is currently no Bitcoin trust as large as Grayscale in the Hong Kong market, so even if the Bitcoin trust in the Hong Kong market is converted into an ETF and begins to have redemption operations, it is unlikely to see such a large-scale sell-off.
However, even if Grayscale continues to sell, the overall inflow and outflow of Bitcoin spot ETFs in the United States still showed a net inflow as of 9 am today (UTC+8), and the OKEx Research Institute calculated that it was about 6.05 million US dollars. Specifically, only Grayscale has a continuous outflow, while other funds have an inflow.
There are two main reasons for Grayscale's continuous selling: First, compared with other fund companies, Grayscale has the highest management fee, which means that investors who buy $100 million of IBIT and the same size of GBTC will save $1.38 in management costs; second, Grayscale is different from other newly issued Bitcoin spot ETFs in that it operates by converting trusts into ETFs. This allows investors who previously purchased GBTC at a discount to take advantage of the discount and the rise in Bitcoin prices to sell for arbitrage without redemption and repurchase.
According to the observations of OKLink Research Institute and the data on the OKLink chain, Grayscale began transferring on-chain assets to the Coinbase Prime hot wallet address almost every working day two weeks ago. And since January 2024, 1, Grayscale's outflow trend for 23 consecutive days has gradually weakened.
The launch of the Bitcoin spot ETF has achieved a close connection between the traditional financial market and the virtual asset market, marking the opening of the structured financial market to the virtual asset field. According to Technavio's estimates, from 2023 to 2028, the global structured financial market (Note 1) is expected to grow by approximately US$9976.8 billion, with an average annual growth rate of 11.8%.
As compliance and market maturity continue to improve, the launch of a Bitcoin spot ETF will mean standardizing Bitcoin as a financial product in the form of a spot ETF.
Spot ETFs provide investors with a more convenient and standardized way of investing. Moreover, standardized products can enhance the efficient operation of the market and more effectively manage risks and protect investors. The large-scale adoption of compliance assistants that we proposed at the beginning of 2023 is coming to us in a flourishing manner.
Note 1: The global structured finance market covers a variety of complex financial instruments, which are characterized by being supported by an underlying asset pool. Some common structured financial products include: securitization products, derivatives, debt instruments, structured derivatives, financial engineering products, etc. Here, Bitcoin ETF, as a type of securitization product, belongs to the structured finance market.
Author: Hedy Bi, OKLink Research Institute