Hong Kong is poised to become the first major financial hub in Asia to allow Bitcoin exchange-traded funds (ETFs) that use either ‘in-kind’ or ‘cash creates’ methods. This is a significant development for the crypto industry, as it could open up new opportunities for investors and fund managers in the region.

What are ‘in-kind’ and ‘cash creates’ methods?

In simple terms, these are two different ways of creating and redeeming shares of an ETF. An ETF is a type of fund that tracks the performance of an underlying asset, such as Bitcoin, and trades on a stock exchange like a regular stock.

An ‘in-kind’ method means that the ETF issuer and the authorized participant (AP), who is responsible for creating and redeeming ETF shares, exchange the underlying asset directly. For example, if an AP wants to create 100 shares of a Bitcoin ETF, they will deliver 100 Bitcoins to the ETF issuer, and receive 100 ETF shares in return. Similarly, if they want to redeem 100 shares of the ETF, they will return 100 ETF shares to the issuer, and receive 100 Bitcoins back.

A ‘cash create’ method means that the ETF issuer and the AP use cash instead of the underlying asset to create and redeem ETF shares. For example, if an AP wants to create 100 shares of a Bitcoin ETF, they will pay the market value of 100 Bitcoins in cash to the ETF issuer and receive 100 ETF shares in return. Similarly, if they want to redeem 100 shares of the ETF, they will return 100 ETF shares to the issuer, and receive the market value of 100 Bitcoins in cash back.

What are the advantages and disadvantages of each method?

Both methods have their pros and cons, depending on various factors such as liquidity, cost, risk, and regulation. An ‘in-kind’ method can reduce the tracking error of the ETF, which is the difference between the ETF price and the underlying asset price. This is because the ETF issuer does not need to buy or sell the underlying asset in the market, which can incur transaction costs and price slippage.

An ‘in-kind’ method can also reduce the counterparty risk of the ETF, which is the risk that one party fails to fulfill their obligations. This is because the ETF issuer and the AP do not need to rely on intermediaries such as custodians or brokers to handle the underlying asset.

However, an ‘in-kind’ method can also pose some challenges, especially for crypto assets such as Bitcoin. For instance, an ‘in-kind’ method requires that both the ETF issuer and the AP have access to secure and reliable storage facilities for the crypto assets.

This can increase the operational complexity and cost of running an ETF. Moreover, an ‘in-kind’ method may face regulatory hurdles in some jurisdictions, where crypto assets are not recognized as legal tender or securities.

A ‘cash create’ method can overcome some of these challenges, as it does not involve the physical transfer of crypto assets. A ‘cash create’ method can also increase the liquidity of the ETF, as it allows more market participants to create and redeem ETF shares without having to own or handle crypto assets.

Furthermore, a ‘cash create’ method may be more compatible with existing regulatory frameworks, as it does not require any changes in the legal status or treatment of crypto assets.

However, a ‘cash create’ method can also introduce some drawbacks, such as higher tracking error and counterparty risk. A ‘cash create’ method can increase the tracking error of the ETF, as it exposes the ETF issuer to market fluctuations when buying or selling crypto assets in order to match the demand and supply of ETF shares.

A ‘cash create’ method can also increase the counterparty risk of the ETF, as it depends on more intermediaries such as custodians or brokers to facilitate the cash transactions.

Why is Hong Kong allowing both methods?

According to a recent report by Bloomberg, Hong Kong’s Securities and Futures Commission (SFC) is set to approve spot Bitcoin ETFs that use either ‘in-kind’ or ‘cash creates’ methods by early next year. The report cites unnamed sources who claim that the SFC has been in talks with potential issuers and has been receptive to both methods.

The SFC has not officially confirmed or denied this report, but it has previously indicated its openness to regulating crypto products under its existing rules. In November 2018, the SFC issued a statement outlining a new regulatory framework for virtual asset portfolio managers, fund distributors, and trading platforms. The statement also mentioned that some virtual asset funds may be authorized as collective investment schemes under its existing regime.

By allowing both methods for spot Bitcoin ETFs, Hong Kong may be aiming to strike a balance between innovation and regulation in its crypto market. By offering more choices for investors and fund managers, Hong Kong may be able to attract more capital and talent to its crypto industry. By imposing strict requirements and oversight on the ETF issuers and APs, Hong Kong may be able to ensure the safety and soundness of its crypto market.

What are the implications for the global crypto industry?

If Hong Kong approves spot Bitcoin ETFs that use either ‘in-kind’ or ‘cash creates’ methods, it could have significant implications for the global crypto industry. Hong Kong is one of the largest and most influential financial centers in Asia, and its regulatory stance could influence other jurisdictions in the region and beyond.

Hong Kong’s move could also put more pressure on the US Securities and Exchange Commission (SEC), which has so far rejected or delayed several applications for spot Bitcoin ETFs. The SEC has expressed concerns about the market manipulation, fraud, and custody issues associated with crypto assets. The SEC has only approved Bitcoin futures ETFs, which track the price of Bitcoin futures contracts rather than the actual Bitcoin.

However, some industry experts and advocates argue that spot Bitcoin ETFs are more beneficial for investors and the crypto market, as they provide more direct exposure to Bitcoin and reduce the reliance on third-party intermediaries. They also point out that other countries such as Canada, Brazil, and Germany have already approved spot Bitcoin ETFs without any major issues.

Therefore, Hong Kong’s approval of spot Bitcoin ETFs that use either ‘in-kind’ or ‘cash creates’ methods could set a new precedent and standard for the global crypto industry, and potentially pave the way for more widespread adoption and acceptance of crypto assets.