Hong Kong approved Bitcoin and Ethereum ETFs: Could the in-kind ETF model be significant?

What is Hong Kong's initial approval about?

In the end of 2023, Hong Kong's Securities and Futures Commission (SFC) published rules for authorised funds with exposure to virtual assets. The published circular laid down requirements under which Hong Kong’s financial regulators would consider approving investment funds with exposure to virtual assets. 

In April 2024, Hong Kong's Securities and Futures Commission (SFC) issued conditional approvals to three off-shore Chinese Asset managers to start issuing spot Bitcoin and Ether ETFs. These asset managers that received approval include Bosera Asset Management, China Asset Management, and Harvest Global Investments. 

The U.S. was the first jurisdiction to approve Bitcoin ETFs in January 2024. To learn more about U.S. Bitcoin spot ETFs, why not read this article: 'Bitcoin spot ETFs are here: How do I buy Bitcoin ETFs?'.

Reasons behind the initial approvals

The Hong Kong SFC noted that the virtual assets’ landscape has been evolving rapidly, involving a wide range of investment products providing crypto exposure such as crypto exchange-traded funds (ETFs) available to both professional and retail investors. 

Because the demand for crypto investment products has expanded in Hong Kong, the SFC decided to introduce new regimes that regulate this area and provide the offering of virtual assets products with a substantial degree of investor protection safeguards. 

Additionally, Hong Kong’s financial regulator noted it started to accept applications for ETFs with exposure to crypto assets through futures contracts back in October 2023. 

How will it be carried out?

Hong Kong spot crypto acquisitions and transactions by funds authorised by the SFC must be carried out through licensed crypto trading platforms or authorised financial institutions. They must comply with all of the regulatory requirements of the Hong Kong Monetary Authority (HKMA) 

As opposed to the model approved by the U.S. Securities and Exchange Commission (SEC) which is based on the cash model of spot Bitcoin ETFs, Hong Kong spot ETFs include both cash and in-kind models. Therefore, in-kind and in-cash subscriptions and redemption are enabled for SFC-authorised Hong Kong spot ETFs.

Understanding the in-kind ETF model

Hong Kong decided to embrace both in-kind and cash-create models for Bitcoin ETFs. However, the in-kind model is typically preferred by investors and issuers for tax, liquidity, and cost-related reasons. 

Several industry experts highlighted the significance of the in-kind redemption model as being generally more efficient. For example, exchange-traded products for all spot-market commodities such as gold and silver, utilise in-kind models and redemptions with the underlying asset. 

It is believed that in-kind redemption models turn out to be more efficient for spot commodity exchange-traded products; due to fewer steps in the process and, as claimed by several industry experts, less operational risk involved, it could be more efficient to utilise in-kind orders.

The difference between the in-kind and cash model of ETFs

The in-kind approach is claimed to be a potentially smoother and cheaper process that might boost the appeal of Hong Kong products. In other words, the products will have an in-kind subscription and redemption mechanism, meaning Bitcoin and Ether tokens can be swapped for ETF units and vice versa.

Unlike Hong Kong’s model, the U.S. model of spot Bitcoin ETFs limits these products to cash-only transactions. A cash redemption model means that ETF shares can be exchanged only for cash.  

The cash redemption model treats Bitcoin ETF shares like cash, selling the Bitcoin to fulfil the redemption as opposed to the in-kind model which treats shares more like actual Bitcoin and transfers the underlying asset directly. 

From the traditional finance’s angle, an ETF issuer has the opportunity to satisfy redemptions and portfolio rebalances in-kind such as exchanging securities for ETF shares, rather than selling securities for cash. In-kind activity doesn’t trigger a taxable event for the ETF and can cover shareholders of the fund from capital gains that stem from the trading actions of other shareholders.

Industry responses and market predictions

Hong Kong’s initial approval was welcomed with a lot of enthusiasm from the crypto community which thought that the creation of in-kind redemptions for spot Bitcoin and Ether ETFs would be huge.  

Since the Asian crypto market is larger than the U.S. crypto market in terms of volume, listed ETFs in Hong Kong could channel ‘new money’ into approved portfolio allocation. The initial approval also suggests that there is a closer tie between crypto assets and the region. 

When it comes to predictions on the future impacts of these ETFs, many industry experts claimed that the initial approval signifies a potential for significant capital inflows and the possibility of sustaining uninterrupted trading flows and better market liquidity. 

However, not all forecasts have been optimistic. For example, Bloomberg ETF analyst Eric Balchunas laid down a more restrained prediction, stating that mainland China investors might be restricted from participating in these ETFs due to existing regulations along with the prediction that Hong Kong spot ETFs could be less productive than the U.S. spot Bitcoin ETFs.

Potential challenges

Aside from the benefits provided by the initial approval of Hong Kong spot Bitcoin and Ether exchange-traded funds, the broader economic context needs to be considered.  

With the ongoing inflation and geopolitical events affecting market sentiment, it is difficult to determine the path of Hong Kong ETFs.  

For example, there has been a growing concern among several industry leaders that risk assets, such as stocks and cryptocurrencies, stand on the edge of a broad price correction due to persistent inflation as the primary trigger. Additionally, they noted that since the bond market is currently projecting less than three cuts, there might be a tipping point for risk assets. 

On the bright side, Hong Kong’s initial approval set out a precedent in the region as it reflects a growing interest in integrating crypto assets within traditional financial systems. Such a regulatory move could encourage other countries in Asia to do the same and expand overall crypto adoption. 

If you are new to the crypto market, it might be challenging at times to understand all of the implications it brings to the table. Remember that education is the key to understanding the crypto space. You can start your crypto journey by selecting one of our LearnCrypto Academy courses.