A New Chapter in Hong Kong Web3 Regulation: Balancing Compliance and Innovation

On May 31, the Hong Kong virtual asset trading platform's exit policy officially came into effect, and non-compliance exchanges will cease operations. As the deadline approaches, about half of the VATP applicants have chosen to withdraw, sparking widespread discussion in the market. Some pessimistic voices believe this signifies the decline of Hong Kong as a financial center, even asserting that Hong Kong's Web3 era ended just as it began. But is that really the case? How should regulatory authorities respond to the challenges of Web3?

In fact, Hong Kong's strategic position as a Web3 bridge connecting the East and West has just begun to emerge.

The Next Decade of Web3: Comprehensive Compliance

From a global perspective, Hong Kong's current regulatory attitude is not an isolated case. Looking at the major Web3 financial markets around the world, we can identify a common trend.

Japan, as a pioneer in Web3 regulation, began its regulatory process as early as 2014 after the Mt.Gox incident and introduced a licensing system for cryptocurrency exchanges in 2017. To date, Japan has 23 approved cryptocurrency exchanges, most of which are domestic companies. Japan's regulatory requirements share similarities with those of Hong Kong, such as asset segregation and the use of cold wallets, which played a positive role during the FTX crisis.

Singapore and the United States have strengthened regulatory efforts after the Three Arrows Capital and FTX incidents in 2022. Although the United States does not have a formal "Compliance" exchange, the publicly listed company Coinbase has performed well in terms of regulatory compliance and has seen significant growth in recent performance. Meanwhile, other offshore exchanges, such as certain platforms, are facing more regulatory challenges following the FTX incident.

These cases indicate that regulation is evolving towards a more specialized and refined direction. Although Japan and Singapore were once criticized for being too strict during the early stages of regulation, the Web3 ecosystems in both regions are becoming increasingly active as policies continue to improve.

The recently released FIT21 (Financial Innovation and Technology Act of the 21st Century) regulatory framework in the United States proposes definitions for digital assets (including DeFi and NFTs) and standards for distinguishing between commodities and securities, which could have a profound impact on the cryptocurrency industry.

Following closely, Southeast Asia, Dubai, India, Iran, and other regions also plan to introduce Web3 regulatory policies in the coming years. Even some countries that were previously not very active in the cryptocurrency sector, such as some European countries and Nigeria, are beginning to participate in this wave of regulation.

Global regulators are unwilling to miss the opportunities of Web3. Regardless of the starting point, all jurisdictions will ultimately move towards precise regulation. From the perspective of the number of licensed exchanges, local enterprises dominate, and the proportion of offshore exchanges is usually no more than 30%.

This is not only a challenge for regulation but also a problem faced by offshore exchanges. During the period of relaxed regulation, offshore exchanges served nearly 200 million users. But that era has passed. Apart from some large exchanges willing to pay hefty fines for Compliance, others such as certain platforms among those that withdrew applications have obtained licenses in places like Singapore and Dubai, while some have received fewer licenses.

For offshore exchanges, entering major financial regulatory areas is not easy. The era of "regulatory arbitrage" in the crypto market has ended.

Compared to the "operate first, regulate later" model in the United States, Hong Kong has adopted a "license first, operate later" strategy. Since the introduction of Web3 regulatory policies in Hong Kong in 2022, the trend towards full compliance in the industry has begun. By June 1, 2024, the AMLO license will be officially implemented, and non-compliant exchanges will be phased out. Currently, more than half of the applicants are still present. Licensed exchanges, such as a certain trading platform, have seen trading volumes exceeding HKD 440 billion, indicating a positive development trend.

Therefore, the exit of some exchanges should not be viewed with excessive pessimism. From a historical perspective, this is merely a necessary cleanup process that Hong Kong and other regulatory areas must go through. More importantly, the 531 policy marks that Hong Kong has addressed the most complex regulatory challenge of "exchanges," which involves the highest concentration of capital, completing a key step towards comprehensive regulation.

Hong Kong and the United States: The East-West Web3 Game

What is the next step after the regulation is completed? The game period has just begun.

Four years ago, the founder of PayPal predicted that future political conflicts would focus on the artificial intelligence of communism and the cryptocurrency technology of liberalism.

Today, both AI and Web3 are gaining strong momentum, with the United States and Hong Kong being seen as the bridgeheads of the Web3 industry between the East and West. The interplay of regulatory attitudes in these two regions will lead the global development direction of Web3.

Why is competition necessary? Unlike AI, monopolistic regulation in the Web3 era is no longer feasible. Web3 has established more business models based on the network economy, which can easily cross physical boundaries to provide services to customers.

The book "The Sovereign Individual" once described this scenario: "Due to the development of information technology, you will soon be able to create wealth in cyberspace, completely free from the plunder of nation-states. This will form a de facto demand for a meta-constitution, where the government must genuinely provide satisfactory services before demanding you to pay your bills."

In the future, political leadership may increasingly resemble entrepreneurship, where only being sufficiently friendly can attract capital and talent inflow. It is not Web3 that needs to be regulated, but rather regulators that need Web3.

The recent attitude of the United States has become very clear. This year, the topic of cryptocurrency has for the first time become a central issue in American politics. According to a certain data platform, about one-third of American voters consider a candidate's stance on cryptocurrency before voting. 77% of voters believe that presidential candidates should at least understand cryptocurrency. 44% of voters somewhat agree that "cryptocurrency and blockchain technology are the future of finance." Some political figures have even called for: "Ensure that the future of cryptocurrency happens in the United States!"

The pattern of competition between the East and the West has already formed, with ETFs becoming a clear battlefield. The sudden shift in the US attitude towards ETH ETFs may be related not only to domestic factors but also to Hong Kong's early launch of the ETH ETF in April.

Although there is currently a gap in scale between Hong Kong and US ETFs, as one of the world's largest offshore financial centers, it is expected that with the improvement of the ecosystem, Hong Kong will attract more institutions to participate, leading to a new round of institutional bull market.

In the future, the ETH ETF, as a stakeable income-generating asset, is expected to become the next focal point of competition. After Ethereum transitioned from PoW to PoS, it can generate passive income similar to interest through staking, with the current market annual interest rate at around 4.5%. If Hong Kong takes the lead in launching a spot ETF for Ethereum with staking functionality, subscribing to the ETF will no longer be a paid action but a profit-making one after receiving staking rewards. This could, to some extent, become a "digital U.S. Treasury bond," and its appeal may even surpass that of the Bitcoin ETF.

The development of the Web3 industry is closely related to the local cultural heritage. Although Easterners may appear more reserved and cautious compared to the outward-looking and diverse West, this does not mean they are lagging behind.

Hong Kong has currently issued multiple regulatory documents, including the "Guidelines for Virtual Asset Trading Platform Operators" and the "Guidelines for Combating Money Laundering and Terrorist Financing." These policies are clearer and more mature than the previously used "Commodity Futures Trading Commission Regulations" in the United States, and they avoid the confusion over whether cryptocurrencies are "securities" or "commodities."

As the bull market gradually approaches, the wealth effect in the industry will become more pronounced, and a new batch of billionaires is about to emerge. Hong Kong, as a region that naturally possesses the advantage of "Eastern mysterious power," will also attract more Web3 talent and funds from both the mainland and overseas Chinese as the market conditions improve.

In the next cycle, Web3 will integrate with traditional finance on multiple dimensions, injecting new vitality into the Hong Kong financial market. Currently, the Hong Kong Securities and Futures Commission has indicated that it may open up STO and RWA investments to retail investors, further expanding the virtual asset market. Additionally, the regulatory framework for Hong Kong's HKD stablecoins and over-the-counter (OTC) virtual asset shops is also being advanced. Once the full chain is connected, Web3 will bring new momentum to the entire Hong Kong market.

In this historical wave, which enterprises can stay at the table? Exchanges are undoubtedly the most important cornerstone in Hong Kong's Web3 ecosystem.

In the foreseeable future, licensed exchanges that remain in the market will not only engage in their own trading operations but also become key connectors across various financial sectors in Hong Kong's Web3. For instance, during this ETF issuance, a certain trading platform also acted as the custodian, providing underlying infrastructure support for the issuer. In the future, these exchanges will play an indispensable role in RWA, STO, and OTC businesses.

It is precisely for this reason that some offshore exchanges have been forced to leave the table in Hong Kong. This also confirms the old saying: "If you come out to mix, you will eventually have to pay it back."

Development always has its ups and downs. We should rationally judge from a historical and global perspective during the period of the clean-up in Hong Kong. The story of Web3 in Hong Kong is far from over; on the contrary, it may just be beginning.