1. Interpretation of the Hong Kong Virtual Asset Index Policy
Since the Hong Kong government released its Web 3.0 vision last year, both traditional institutions and Web 3.0 companies have paid special attention to the market opportunities therein. Recently, with the official release of the regulatory documents on virtual asset trading by the Hong Kong Securities and Futures Commission, the future focus areas have become clearer, with virtual asset indices being one of them.
According to the policy document, digital virtual assets will have an important strategic position in the future Hong Kong market: the regulator requires virtual assets available for retail trading to be included in at least two different virtual asset indices launched by at least two accepted index providers. This means that virtual asset indices will become the main arbitrators of “retail trading assets”.
In order to further clarify which are qualified virtual asset indices and to prevent interest transfer issues, the Hong Kong Securities and Futures Commission has clearly stated:
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(1) virtual asset indices issued by virtual asset issuers and exchanges are not qualified;
(2) at least one index should comply with the “Financial Benchmark Principles” and be launched by a company with index experience in the traditional securities market.
From the above regulations, this actually gives traditional financial companies a kind of “franchise” – virtual assets that are not included in the indices issued by traditional financial companies are not allowed to provide trading to retail investors.
So, as for the current virtual asset indices in the market, which virtual assets may be allowed to provide trading to retail investors? According to the market data, the institutions that currently provide virtual asset indices and are recognized by the market are mainly Galaxy, 21Shares, CF Benchmarks, Bitwise, Wisdomtree, and Wilshire.
Among them, Galaxy cooperates with Bloomberg to issue virtual asset indices; CF Benchmarks’ indices have been widely used on CME and Nasdaq; and Wilshire, as an old index issuer, currently cooperates with the Financial Times to issue virtual asset indices, so it can be considered that the above three companies are “companies that comply with the” Financial Benchmark Principles “and have experience in issuing indices in the traditional securities market.”
After sorting the market data, it can be found that, under the conditions required by the Securities and Futures Commission, there are a total of 13 encrypted assets that can be used as alternative materials for retail trading, namely: BTC, ETH, ADA, SOL, MATIC, DOT, LTC, AVAX, UNI, LINK, AAVE, BCH and CRV.
Of course, the above currencies may not be allowed to be traded by retail investors. Because the assets available for retail trading must meet the three conditions of “exchange due diligence + qualified large-scale virtual assets + CSRC written approval”. For example, the operating conditions of SOL and BCH are not optimistic and may be excluded by the CSRC.
Table 1 Virtual Asset Index Issuance Status
(Source: Meta Lab)
Table 2 Alternative Virtual Assets Available for Retail Customers to Trade
(Source: Meta Lab)
II. Feasibility Assessment of Virtual Asset Index Business
Until today, the development of the virtual asset index business is still a new topic for the Web 3.0 industry. The main reason is that the index business is generally established in a compliant and mature market as a market benchmark and performance benchmark. However, in the past decade, the virtual asset market has been in its early barbaric stage, with few high-quality assets with good liquidity, and a lack of asset management institutions in the market, making it difficult for index businesses to survive. Therefore, although there have been many start-ups doing virtual asset indexes in the past five years, only a few have survived. Nowadays, with the compliance of the Hong Kong market, especially when the regulatory authorities in Hong Kong put the index in an important position, the virtual asset index business has ushered in a new round of development opportunities.
1. Business feasibility analysis
As mentioned earlier, due to the immaturity of the virtual asset market, many index start-up companies that have appeared on the market in the past five years have almost disappeared, and the surviving enterprises are mainly divided into the following two categories:
First, issue asset management products based on the preparation of virtual asset indexes. Typical representatives such as Galaxy and Bloomberg have issued Galaxy Crypto Index Funds after cooperating with the index; similarly, 12 Shares has issued a large number of virtual asset ETPs. At present, most companies with index business are like this.
Second, combine virtual asset indexes with news and information, such as the FT Wilshire Top 5 Digital Assets Index, which is jointly issued by the old index publishing company Wilshire and the Financial Times, and provides market information for readers in the Financial Times.
Considering the trend of virtual assets gradually complying and being included in the traditional financial market, there will not be a need for many virtual asset indices in the future, and the commercial form will gradually converge with the traditional market. Therefore, the index business model of the traditional securities market is worth referring to.
Taking the American Standard & Poor’s Company as an example, the company’s index business (Standard & Poor’s Dow Jones Index) currently accounts for approximately 11% of its total revenue, and index revenue has three main sources: asset-linked fees, subscription fees, and sales royalties.
From the actual operation of S&P, the index business shows the following three characteristics:
Firstly, the gross profit margin and operating profit margin of the index business are very high. Taking S&P as an example, in the past ten years, S&P’s index business has maintained an average gross profit margin of about 83% and an average operating net profit margin of about 65%, higher than S&P’s total comparable indicators. The main reason is that if inflation factors are deducted, the cost of the index business is relatively fixed. With more customers using it, scale effects will be formed, leading to a decrease in cost rates and a high profit margin.
Figure 1 S&P’s gross profit margin in the past ten years
(Data source: Wind, Meta Lab)
Figure 2 S&P’s operating net profit margin in the past ten years
(Data source: Wind, Meta Lab)
Secondly, the income increment of the index business is high. In the past ten years, the revenue of S&P’s index business has increased from USD 490 million in 2013 to USD 1.34 billion in 2022, which can be said to be a considerable increment. The main reason is that in the past decade or so, the global index fund and ETF scale has grown from USD 1 trillion in 2008 to around USD 10 trillion at the end of 2022, accompanied by the growth of index-linked fees.
Figure 3 S&P’s revenue (in USD ten thousand) in the past ten years
(Data source: Wind, Meta Lab)
Finally, the scale of revenue from the index business is limited. According to industry estimates, the scale of the index business in the traditional securities market does not exceed USD 10 billion. It is especially noteworthy that even for head companies in the index business like S&P, the main source of operating revenue is not the index business. Looking at the revenue proportion in 2022, the market intelligence and rating business accounted for more than 60%, while the index business only accounted for 11.8%.
Figure 4 Composition of S&P Company’s Business Revenue in 2022
(Data Source: Wind, Meta Lab)
2. Future Development Evaluation of Virtual Asset Index Business
Looking at the historical development of traditional index businesses, market indices were born in the second half of the 19th century (with the Dow Jones Index in 1884), mainly providing market information as financial indicators. However, their profitability has always been problematic. It was not until the 1960s that the business model of index business gradually became clear. With the emergence of ETF and mutual fund products tracking indices in the 1970s, indices officially became investment targets from investment benchmarks, making it possible to charge asset-hanging fees. In 1993, the US SEC issued the final rules on the disclosure of mutual fund performance and investment portfolio managers, which for the first time required mutual funds to provide specific performance benchmarks to investors, and stipulated that funds should compare their returns with appropriate securities market indices in the form of trend charts. Indices have also become a necessary benchmark for evaluating fund performance, and major asset management companies have begun to pay subscription fees to index companies.
It can be seen that the maturity of the profit model of traditional indices in the securities market is mainly due to the rise of index-based asset management products and the regulatory requirements of SEC to provide performance benchmarks. In the current field of virtual asset index business, institutional clients are not yet mature, and the number of institutions is relatively small compared to index clients. Index-based products are relatively scarce, mainly focusing on bitcoin and Ethereum ETFs.
Based on the above reality, the author believes that the virtual asset index business in the Hong Kong region will mainly have three characteristics in the future:
(1) Those who engage in virtual asset index business currently need to be prepared for the fact that the business will not be profitable for the next 3-5 years. The key to its profitability in the future lies in whether the virtual asset derivatives market will be lifted. If the derivatives market is open to the public, the index will most likely be used as a reference price for derivatives. It can charge a certain amount of royalties to exchanges or issuers. Alternatively, after the derivatives market is opened, professional asset management institutions in the virtual asset field will increase and issue more index-based products.
(2) The virtual asset index business should be treated as a subsidiary business rather than a core business. As mentioned earlier, companies that historically have index businesses do not primarily engage in index businesses, but rather in rating and intelligence businesses.
(3) Virtual asset index business is more suitable for traditional financial institutions than for Web3.0 start-ups. The main reasons, in addition to the qualification requirements for index providers mentioned earlier by the SFC, are market competitiveness – corporate brands and reputations have a significant impact on index business. For example, it is self-evident which has stronger market credibility and dissemination power between virtual asset indices released by Bloomberg and start-ups.
Of course, index business is a business that pursues “long-termism”. As can be seen from the analysis of Standard & Poor’s in the previous section, although index business is difficult to make profits in the early stages, once the virtual asset market matures further, there may be scale advantages and low-cost, high-profit margins for first-movers.
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