Could we be on the cusp of seeing a licensed fund operator introduce a crypto investment product, with the approval of a globally respected regulator?
In Europe, Lichtenstein’s Bank Frick offers its well-heeled clients direct access and cold storage of five crypto-currencies. In Switzerland, Falcon Bank allows its clients to exchange and hold crypto, a move allowed by Finra, the securities regulator.
But Hong Kong could be the first jurisdiction to give some kind of approval to an asset manager launching a fund in this space. And it could happen soon. DigFin has learned of at least one licensed fund manager working on structures for tax and trusteeship that it hopes the Hong Kong Securities and Futures Commission will accept, so that it can launch a pair of tracker funds in June. The company declined to comment.
Open the door to institutions
Any such fund, if it gets approved, would be reserved for what the SFC deems professional investors (rich people, family offices, hedge funds – but not retail).
“We’re doing this to build the ecosystem,” said someone involved in the discussions. Noting a high level of activity among other participants seeking the SFC's green light on crypto-related products, he said, “We want to develop a track record before the bitcoin brogrammers in flipflops and T-shirts come in and ruin it for everybody.”
Henri Arslanian, consulting director at PwC, told DigFin, “Some institutional investors want exposure to crypto assets, but they don’t know where to start. Investing in a crypto fund could be an easy first step to access the sector.” Such a product would also enable more traditional fund managers to consider entering the space, he says.
Custody: how much is enough?
But many boxes need to be ticked first, given the heavy compliance around managing client money, and issues around tax. Offshore funds in Hong Kong often don’t need to pay tax locally. Arslanian says the current tax regime is not inclusive of crypto funds, but the offshore fund regime could be potentially amended to include crypto assets: “If the goal is to attract more fund managers to come to Hong Kong, why not include crypto fund managers?”
Any offering will require service providers in order to develop a corporate and fund structure that will satisfy investors and regulators, including a trustee, lawyers and tax specialists. Custody remains a challenge. Blockchain technology eliminates the role for third-party custodians (or, more specifically, the tech doesn’t allow room for one). This is a huge problem for investors and regulators, because self-custody is considered a governance no-no. But traditional custodians will not handle bitcoin or ether.
If the goal is to attract more fund managers to Hong Kong, why not include crypto fund managers?
Customer onboarding is another important element in winning the regulator’s trust. The KYC will probably be old school: any prospective customer has to show up in person at a distributor’s office and go through a questionnaire, as they would with a traditional investment product. Finally, the manager will need to provide incentives to distributors, such as salespeople at private banks, so the fund will likely carry fees akin to active funds, even if it's a beta product.
Making it sell
Will the SFC acquiesce? In general, regulators are focusing more on the risks of crypto-currencies rather than the opportunities for Hong Kong as a financial center. Julia Leung, deputy CEO at the SFC, warned in March that many initial coin offerings – fundraisings in token form – are “dubious, if not downright frauds”.
“The need for a crypto fund is massive,” says Jehan Chu, co-founder of Kenetic Capital, who has told DigFin his firm is supporting initiatives to introduce licensed products, but is not itself licensed to do so. “But some people are conservative because they spend their time wondering what the regulators think,” he said.
Some people spend their time wondering what the regulators think
Regulators are justifiably nervous about volatility in crypto markets, and the vulnerability of exchanges to hacks. Some are trying to encourage the industry but without formally approving products. Switzerland and Singapore, for example, have been quicker to outline rules for initial coin offerings, notes Rocky Mui, a lawyer at Clifford Chance in Hong Kong.
Meanwhile small offshore centers such as Malta and Gibraltar are trying to be recognized as regulated markets for ICOs and trading crypto-currencies, but their authorities lack the gravitas of Hong Kong's. If the SFC allows a licensed asset manager to offer crypto funds to professional investors, it would put the city at the forefront of a nascent but burgeoning industry, and create a lot of jobs along the way.