Hong Kong Has Opened the Door for Crypto ETFs

The Hong Kong watchdog has listed multiple requirements for interested ETF managers. In the initial stage, products will have to be backed by futures contracts traded on regulated exchanges specified by the SFC. Futures will either be buying into Bitcoin or Ethereum. For now, only Bitcoin futures and Ethereum futures traded on the Chicago Mercantile Exchange are allowed. That means ETFs that invest directly in spot virtual assets are out of scope, a rule similar to that of the U.S.

Managers of a virtual assets ETF will also have to demonstrate at least three years of proven track record in managing ETFs. In terms of investment strategy, managers are expected to go active. As such, they will retain their flexibility in portfolio composition, futures rolling strategy, and handling of any market disruption events. To manage the leverage level, the net derivatives exposure of an ETF shall not exceed 100% of its total net asset value. Existing conduct requirements for derivative products will apply for intermediaries, which must also comply with the virtual asset-knowledge test requirements. 

The Rise of Crypto ETFs Has Begun

One week ago, Fidelity International announced that it has launched its first Bitcoin exchange-traded product for professional investors in Hong Kong. The product, the first of such kind in Asia, is backed by physical ownership of bitcoin.

For retail investors in Hong Kong, though, U.S.-domiciled ETFs and funds have been accessible via online brokers. As of this writing, U.S. exchange-listed products are banned from tracking the spot market prices of cryptocurrencies.

Morningstar's digital assets fund category (U.S. only) now comprises 50 funds. While some funds give investors exposure to the asset class with direct ownership or with the use of futures contracts, this group also captures funds with a portfolio of companies involved in digital assets trading, cryptocurrency mining, blockchain technology, and more.

This broad asset class manages around US$ 20 billion. So far this year, managers have launched 10 new funds, while 28 others came to the market in 2021.

Which Funds Own the Most Assets? And How Do They Perform?

The oldest one, Grayscale Bitcoin Trust (GBTC) was launched in September 2013. The US$ 12.9 billion fund, investing directly in bitcoin, is also the largest in the category, representing three-fifths of the market. Grayscale Investments also launched two sister funds in 2017 for other digital currencies like Ethereum and Zcash.

Proshares Bitcoin Strategy ETF (BITO) synthesizes a bitcoin exposure with futures contracts. It manages US$ 679 million as of October 2022 and is the largest ETF in this space.

Amid the bloodshed in traditional financial assets this year, investors in digital assets didn’t fare any better. Bitcoin, the harbinger in the crypto space, has plunged close to 60% year to date. This is after the world’s largest cryptocurrency peaked at its historical high of more than US$ 67,000 in November 2021. After crashing down hard on dampened risk appetites, the price of bitcoin sits slightly under US$ 20,000.

Year to date, US-listed funds investing in these assets lost an average of 60.4% over the same period. Over a longer interval, investors gained 22.4% and 3.4% each year in the past three and five years, respectively.

Risks from Crypto and Futures

A digital assets futures ETF implies two major risk exposures, both the risks of investing in virtual assets, which has been an immensely volatile asset class, and the risks of investing in futures ETFs, which have the contango problem and capacity concerns. 

Thus, investors need to understand how the risks in the virtual assets market may translate to the futures, and ultimately to the ETFs. Jackie Choy, Morningstar’s director of passive investment ratings, says: “Like any other investments, investors should understand the nature and specifics of the products before investing into virtual asset futures ETFs.”

He says, in particular, virtual asset futures ETFs utilize futures to obtain exposures to virtual assets. “Investors should understand the operations and risks associated with investing in virtual asset futures before making an investment decision.”

Key risks associated with virtual asset futures ETFs include potential large roll costs, which could translate into negative implications on the expected return, especially when compared with the spot market cryptocurrency trends. On the other hand, for investors who would like virtual assets exposure, these ETFs might be used to fill a strategic allocation to crypto in investors’ portfolios rather than as a speculative trading tool.

Asian Regulators Are Rewriting Crypto Rules

Outside of Hong Kong, despite a similar cryptocurrency fervor, the regulatory tone is mixed, with some even cracking down on the whole asset class. One example is China.

In China, transactions in cryptocurrency are prohibited. This is confirmed by a statement by the People’s Bank of China in September 2021 that says that as cryptocurrencies are not issued by the monetary authorities, they do not have legal status equivalent to money and should not be circulated as currency. The central bank cited the trading and speculative activities on virtual currencies were “disruptive to the economy and the financial market”, as they “provided a hotbed for gambling, illegal fundraising, fraud, pyramid schemes, money laundering, and other illegal and criminal activities”.

Unlike China’s hardline approach, Singapore’s attitude is more mixed. With its ambition to become a regional and even global hub for digital assets, the country’s central bank chief says at the Singapore Fintech Festival that the city-state does not want to build a hub for speculating on cryptocurrencies. By that, the authority remains the strictest on curtailing retail access to crypto to “reduce consumer harm”. While the authorities admit that a ban is not likely to work, as the cryptocurrency world is “borderless”, the MAS considers “adding frictions on retail access to cryptocurrencies”. For example, retail investors will likely go through customer suitability tests while they are also barred from the use of leverage for cryptocurrency trading.

The crash of TerraUSD and Luna is also a wake-up call for South Korea’s regulators, which have been reviewing these crypto market events’ “impact on the stability of the financial system, consumer protection, and monetary and economic policies”. The country’s In Thailand, the use of cryptocurrencies as a means of payment for goods and services is banned. Regulators have also overhauled advertising rules for digital asset companies.