Summary
The Hong Kong spot crypto ETFs are unique in two respects. They are the only legitimate vehicles that can 1) accept BTC/ETH via in-kind creation, and 2) convert BTC/ETH into an asset recognized by the Hong Kong banking system as collateral. This appeals to large BTC/ETH holders, who now have a means to be included in the banking system.
Incentivised by its desire to grow Hong Kong into a global financial hub rivaling New York, Beijing can utilize various policy tools to support Hong Kong government’s crypto-hub initiatives. Stock Connect is one of them.
Although the three crypto ETFs are not currently eligible for the Southbound Stock Connect program, the fact that the rules around eligibility have evolved in the past to accommodate changing policy needs suggests that the possibility of crypto ETF eligibility is real.
Figure 1: HK ETFs deserve more than a one-dimensional take
Source: Bloomberg, South China Morning Post, Coindesk
Since its debut four weeks ago, mainstream media has been quick to label Hong Kong’s spot crypto ETF launch as ‘disappointing’ or ‘a failures.’ The negative headlines are often based on the ETF’s much lower initial fund flow data compared to the US ETFs. However, given the significance of the Hong Kong ETFs' listing and their unique positioning, the topic deserves more than a cursory examination. This report aims to do precisely that by examining alternative perspectives and less conspicuous but important developments in recent weeks.
Bitcoin Asia Takeaways
Han Tongli, the CEO/CIO of Harvest Global Investments and one of the three sponsors for the HKEX-listed spot crypto ETFs, shared interesting insights during a panel discussion at the Bitcoin Asia (May 9-10, Hong Kong). His key points can be summarized as below.
The Hong Kong ETFs may become eligible for Stock Connect in future.
The in-kind creation/redemption feature in the HK’s spot ETFs is important for two reasons.
It is an official channel to bring BTC/ETH into the TradFi system, bringing them out of the underground to legitimacy. Once converted into ETF shares via the in-kind creation process, the BTC/ETH wrapped in legally recognized vehicles can be accepted as collateral by the Hong Kong banking system.
Furthermore, this process is performed without going through the US-controlled financial system, which appeals to sovereign states outside the US-sphere of influence (e.g. China, India, some Arabic nations, etc.)
While there is a lot to unpack in these comments, this report will focus on the first point, given its more direct relevance to the investors.
Figure 2: “Empowering Hong Kong: Bitcoin Spot ETF” @ Bitcoin Asia
Source: SCMP
Stock Connect 101
Stock Connect refers to a cross-boundary investment channel that connects the stock exchanges in mainland China and the Hong Kong Stock Exchange (HKEX). Launched in 2014, the program allows investors on both sides of the border to trade shares on the exchanges of the other side using their local brokers and clearing houses. The two bourses in China (Shanghai Stock Exchange and Shenzhen Stock Exchange) each have separate channels to HKEX, referred to as Shanghai-HK Stock Connect (沪港通) and Shenzhen-HK Stock Connect (深港通) respectively. Depending on the direction of the fund flow, the program is categorized as Northbound (from HK to Mainland) or Southbound (from Mainland to HK) Connect.
China officially maintains capital controls, restricting FX trading only for current account transactions (e.g., export/import of goods and services) in principle. Over the years, however, China has experimented with a limited amount of FX trading for capital account transactions (e.g., investment/divestment in assets) in a controlled setting. As one such experiment, the Stock Connect program is subject to various rules regarding both asset types and investment quotas, whereby the number of stocks eligible for the program and the total investment amount is tightly monitored and controlled by the government.
Figure 3: Birds’ eye-view on Chinese equity market
Source: Bloomberg, HKEX, Presto Research
Figure 4: Stock Connect Southbound Cumulative Annual Fund Flow
Source: 360imq.com
Expanding the universe
In 2022, Stock Connect program was expanded to include ‘eligible’ ETFs. To be eligible for Southbound connect, an ETF needs to meet all of the following criteria (Figure 5, 6).
Figure 5: Open for business…
Source: HKEX
Figure 6: …but not to everyone
Source: HKEX
Note that the criteria shown above effectively rules out the possibility of the crypto spot ETF inclusion, as only ETFs whose underlying assets consist of an equity basket can qualify. Currently, out of the total 287 HKEX-listed ETFs, only 10 ETFs meet the criteria (Figure 7).
Figure 7: Privileged Ten
Source: Bloomberg
China’s toolbox
On April 19th, HKEX and the Shanghai/Shenzhen Stock Exchanges quietly proposed the expansion of eligible ETFs under Stock Connect. The proposal for the Southbound are shown in Figure 8 and 9.
Figure 8: Lowering entry barrier
Source: HKEX
Figure 9: Before and After
Source: HKEX
The proposal is subject to regulatory approval and the implementation can take up to three months. Once approved, we estimate the number of eligible ETFs is likely to expand to around 50.
Admittedly, neither the motivation for the proposal nor the reason for the timing of the announcement is clear. Nor does the proposed change allow for the inclusion of commodity-backed ETFs like the three spot crypto ETFs. However, this announcement, when viewed more broadly in the context of how Stock Connect program has evolved over the last few years, is a reminder that the rules around the program are rather flexible and can be adjusted to incorporate the government’s changing policy needs.
Consequently, this means, when assessing the outlook for Hong Kong spot crypto ETFs, myopically focusing on the initial fund inflow or the existing rules will not get you too far. Rather, understanding Beijing's intention behind supporting Hong Kong’s pro-crypto policy is a more effective approach. We have argued that Beijing wants to see Hong Kong strengthen its position as a cutting-edge financial hub rivaling New York, not least driven by geopolitical considerations, and recognizes the role digital assets can play in such endeavors. For more, refer to the April 15th publication of Presto Research’s Weekly Hot Take, Hong Kong's BTC Spot ETF: Trigger for China's Institutional Flow.
Figure 10: China’s plan for stronger Hong Kong
Source: Presto Research
Conclusion
For people with memories of China’s crackdowns on crypto industry, it could be challenging to overcome scepticism on Beijing’s intention and acknowledge nuances. This partly explains the current mainstream narratives on the Hong Kong’s digital asset initiatives, which often fails to go beyond one-dimensional take. Understanding historical context and reading the tea leaves in this part of the world is essential, but it’s not for everyone.
That said, given the global nature of the asset class, China’s role in BTC mining, and the evolving geopolitical landscape, investors are better served by having a more holistic perspective. Remember, there is a reason why China in 2022 suddenly shifted its tone on the digital asset industry. Just like any other government, Beijing is treading carefully in this new field, and just like anywhere else, it ain’t always going to be smooth sailing. But one thing is certain: Beijing has a lot in its toolbox to get the desired outcome.