Last week, two major stablecoin announcements were made to support Hong Kong’s efforts in facilitating the responsible development of its virtual asset ecosystem.[1] On 17 July 2024, the Financial Services and the Treasury Bureau (FSTB) and the Hong Kong Monetary Authority (HKMA) jointly published consultation conclusions on the proposed regulatory regime for stablecoin issuers in Hong Kong (Consultation Conclusions). The following day, the HKMA announced the list of market participants in its Stablecoin Issuer Sandbox (Sandbox), a key initiative that will shape the upcoming regulatory framework.  

PART A – CONSULTATION CONCLUSIONS

In summary, the FSTB and the HKMA found that there was overall support for the policy objectives and the key proposals set out in their consultation paper published on 27 December 2023 (Consultation Paper) (please see our previous update).[2] Therefore, new, stand-alone legislation will be enacted to focus on the regulation of fiat-referenced stablecoin (FRS) issuers in Hong Kong. This FRS regime will be a separate regime from the existing securities and futures and stored value facilities (SVF) regulatory regimes. The FSTB and the HKMA plan to bring the bill into the Legislative Council later this year.  

The Consultation Conclusions provide explanations and guidance in regard to the key elements of the proposals set out in the Consultation Paper, which are summarised below.

What is the scope and of coverage of FRS under the regime?

The proposed definition of FRS in the Consultation Conclusions now primarily focuses on “representations of value which rest on ledgers that are operated in a decentralised manner”. This amends the Consultation Paper’s previous FRS definition by including stablecoins which are “operated on a decentralised distributed ledger or similar technology”[3] as an essential element. Stablecoins operating on digital ledger(s) that are controlled by a single party will not be covered by the regime.

The scope of reference currencies are also (relatively) broad in scope. Unlike other countries’ proposed definitions of regulated stablecoins (e.g. Singapore), Hong Kong’s proposed regime will: (i) cover FRS referencing single currency and FRS referencing multiple currencies, since both categories pose financial stability risks, and (ii) not prescribe the scope of reference currencies of FRS.

Which activities require an FRS license?

As highlighted in our previous update on the Consultation Paper, the proposed FRS licensing regime will apply to issuers who (i) issue an FRS in Hong Kong; (ii) issue (or hold themselves out as issuing) an FRS with reference to the value of the Hong Kong dollar (HKD); or (iii) actively market their issuance of FRS to the Hong Kong public. The HKMA and the FSTB clarified these criteria in the Consultation Conclusions.

  • On what is constituted as an “issuance” activity, the HKMA and the FSTB stated this will generally be decided on a case-by-case basis with respect to specific facts and circumstances. The regulators will provide further guidance on this matter to the industry upon the implementation of the licensing regime.
  • On (i), to determine whether an FRS issuer is issuing an FRS in Hong Kong, the HKMA will consider factors such as the FRS issuer’s place of incorporation, the location of its operations, provision of subsequent customer service to FRS users, and whether a Hong Kong bank account is used to process issuance and redemption requests. The HKMA and the FSTB will provide further guidelines on this matter.
  • On (ii), the regime’s scope will have extraterritorial effect. The HKMA’s regulatory remit will extend to HKD-referenced stablecoins issuance activities carried on outside of Hong Kong. The HKMA will maintain close dialogue with other regulators to foster efficient communication and information sharing. 
  • On (iii), the HKMA will draw on the approached adopted by the Securities and Futures Commission and take into account multiple factors, including, but not limited to, the language used in marketing messages, whether the messages are targeted at a group of people that resides in Hong Kong, and whether a Hong Kong domain name is used for its website to determine whether a person is “actively marketing” an issuance of FRS to the Hong Kong public. Any person (including issuers, agents and intermediaries) promoting unlicensed FRS issuance to the public of Hong Kong would commit an offence. By contrast, agents or intermediaries actively marketing a licensed entity’s FRS issuance will generally not be considered FRS issuers themselves and thus not require a stablecoin issuer license.

What approach will the HKMA take when reviewing FRS licence applications?

The HKMA will consider it appropriate to take into account the use cases and business plans of prospective FRS issuers when reviewing their licence applications. The HKMA has noted that viable and proper use cases are crucial to the sustainability of operations of FRS issuers.

Is local presence an FRS licensing requirement?

Local incorporation will remain as one of the licensing criteria. Non-Hong Kong incorporated companies, other than authorized institutions (AIs) incorporated outside of Hong Kong, intending to apply for an FRS issuer license will be required to establish a subsidiary in Hong Kong. Key management personnel must also have a presence in Hong Kong.

What constitutes “offering” an FRS?

The Consultation Paper included a proposal of allowing only licensed FRS issuers, AIs, licensed corporations and licensed virtual asset trading platforms to offer FRS. The HKMA and the FSTB have now clarified that “offer”, in relation to an FRS, means “communication to the public in any form, or by any means, presenting sufficient information on the term of the offer and channels through which the FRS is to be offered as to enable a person to decide whether to acquire the FRS”.

The HKMA and the FSTB also do not see the immediate need to consider whether to allow SVF licensees to offer FRS. However, they are actively working with the relevant authorities on the possibility of allowing licensed virtual asset over-the-counter service providers (previously discussed here) to offer FRS.

How must FRS issuers manage reserves and maintain the stabilisation mechanism?

  • Quality and Liquidity of Reserve Assets: The amount of FRS issued must always be fully backed by reserve assets at any given point in time that are of high quality and high liquidity, with minimal market, credit and concentration.
  • Investment Limitations: The HKMA will adopt a risk-based regulatory approach and FRS issuers will need to be able to demonstrate how their investment policies for their reserve assets, as well as their liquidity management policies, are appropriate for the size of complexity of their businesses, ensuring they can meet redemption requests during both normal and stressed conditions. The HKMA clarified that, in general, high quality and high liquidity assets may include:
    • coins and banknotes;
    • deposits placed with licensed banks;
    • marketable securities representing claims on or guaranteed by governments, central banks, or qualified international organisations with high credit quality;
    • overnight reverse repurchase agreements with minimal counterparty risk backed by these securities; and
    • tokenised versions of the above assets.

Reserve assets should be held in the same currency referenced by the FRS. FRS issuers will need to obtain prior approval from the HKMA for any currency mismatch between the FRS’ referenced currency and its reserve assets. However, for HKD-referenced stablecoins, the HKMA intends to allow FRS issuers the flexibility to include US dollar-denominated reserve assets.

  • Segregation and Safekeeping of Reserve Assets: Reserve assets should be kept with licensed banks in Hong Kong (Last year the HKMA urged banks to support licensed crypto firms with their legitimate need for bank accounts in Hong Kong). However, the HKMA signalled its openness in considering proposals from licensed FRS issuers on placing reserve assets in other jurisdictions on a case-by-case basis.

In response to requests for clarification on the meaning of “effective trust management”, the HKMA indicated the appointment of independent trustee or a declaration of trust over reserve assets will be considered an acceptable trust arrangement for the purposes of segregating reserve assets from the FRS issuers’ own assets. The FRS issuer must submit a draft of the relevant trust instrument together with a draft of an independent legal opinion for the HKMA’s review.

  • Risk Management Requirements: FRS issuers will need to carry out risk assessments on at least an annual basis, regardless of the business size or risk level of FRS operations.
  • Disclosure and Reporting: The HKMA stood firm on its requirement of monthly attestations of reserve assets conducted by a qualified and independent auditor. However, the HKMA stated its willingness to reduce the frequency of public disclosure regarding FRS in circulation and market value and composition of reserve assets.
  • Prohibition on Paying Interest: The regulators confirmed that FRS issuers will not be allowed to pay interest to FRS users, either by themselves or via third parties. However, the offering of marketing incentives will not be prohibited, provided they do not amount to payment of interest.
  • Various Policies Need to be Maintained: The FRS issuer will be expected to maintain internal policies, including:
    • investment policies;
    • liquidity management policies;
    • reserve management policies; and
    • incident management policies (together with monitoring mechanisms and incident response plans).

What are the redemption requirements of FRS issuers?

FRS users should have the right to redeem their FRS at par value with the FRS issuer and have a claim on the reserve assets on a timely basis. The HKMA clarified that “timely” in the context of processing redemption requests means within one business day in normal circumstances after the day on which a redemption request is received. FRS issuers should seek the HKMA’s prior approval if they foresee any difficulties in fulfilling redemption requests within one business day.

What other business activities can FRS issuers undertake?

FRS issuers will be permitted to conduct certain business activities that are ancillary or incidental to their issuance activities, such as the provision of wallet services in order to facilitate the issuance and redemption processes.

However, FRS issuers will remain restricted from lending or financial intermediation activities due to the associated risks and diversion of resources. Other proposed business activities will be assessed on a case-by-case basis by the HKMA.

What constitutes “adequate financial resources” for the operation of an FRS issuance business?

The HKMA and the FSTB previously proposed in the Consultation Paper that the minimum paid-up share capital on an FRS issuer should be the greater of 2% of the total FRS in circulation and HKD25 million. The HKMA and the FSTB in the Consultation Conclusions relaxed this requirement to 1% of the par value of FRS in circulation or HKD25 million, whichever is higher.

How should FRS issuers address Anti-Money Laundering and Counter-Financing of Terrorism (AML/CFT)?

FRS issuers are expected to adopt a risk-based approach and take appropriate measures for AML/CFT purposes. The HKMA will issue a separate guideline setting out the regulatory AML/CFT requirements, including those related to transaction monitoring and travel rule compliance.

What must should FRS issuers disclose to users?

On top of the disclosure and reporting requirements relating to the management of reserves and stabilisation mechanism (discussed above), FRS issuers must generally provide users with transparent information and appropriate disclosure. The FRS issuer’s publication of a white paper (which also forms part of the licensing application) should contain general information about the FRS issuer, risks associated with using the FRS, the technology used, the mechanism and procedures for issuance, distribution and redemption, the rights of potential FRS users, and applicable conditions and fees for redemption. The FRS issuer should publish the white paper on its website, such that it can be easily accessed by the public, including FRS users.

Can an FRS issuer issue more than one FRS under its license?

An FRS issuer will be able to issue more than one FRS, without the need to set up a separate entity or go through a separate license application process. However, they must provide the rationale, justify the use cases, and obtain the HKMA’s prior consent before issuing a new FRS.

What about the possible overlap or arbitrage with existing regulatory regimes in Hong Kong?

The Consultation Conclusions again addressed concerns about the coverage of relevant existing regulatory regimes, such as the virtual asset service provider (VASP) and SVF licensing regimes. The Consultation Conclusions retained the proposal of regulating FRS via its own dedicated new ordinance (as opposed to existing legislation). The FSTB and HKMA will continue working with the relevant regulators to implement the regulatory regime for FRS issuers with a view to maintaining a coherent virtual assets regulatory framework in Hong Kong thereby avoiding regulatory arbitrage.

Will there be any “passporting” or mutual recognition arrangements?

Given the different levels of progress of regulatory developments across the globe in relation to FRS issuance activities, the FSTB and the HKMA have not set a timeline for putting in place mutual recognition or “passporting”[4] arrangements. However, the regulators will continue to participate in international discussions and monitor regulatory developments in other jurisdictions and consider the merit of putting in place these agreements.

Next steps?

The FSTB and the HKMA will take into account the feedback from respondents in finalising the legislative proposal. They plan to introduce a bill on the regulatory regime into the Legislative Council later this year. As noted in the Consultation Paper and confirmed in the Consultation Conclusions, there will be a six-month non-contravention transitional period, on the condition that FRS issuers apply for a license within the first three months of the commencement of the regulatory regime.

PART B – SANDBOX

On 18 July 2024, the HKMA announced the list of participants in its Sandbox. These participants are namely:

  • JINGDONG Coinlink Technology Hong Kong Limited;
  • RD InnoTech Limited; and
  • a coalition comprising Standard Chartered Bank (Hong Kong) Limited, Animoca Brands Limited, and Hong Kong Telecommunications (HKT) Limited.

Launched in March 2024, the Sandbox allows institutions intending to develop a stablecoin issuance business in Hong Kong to trial their stablecoin operations and engage in two-way discussions on regulatory requirements. True to the premise of a sandbox (i.e. an isolated testing environment), the Sandbox participants must not handle (including raise) funds from the public at the present initial stage, nor offer products associated with the Sandbox. By engaging select industry players before full-scale implementation, the Sandbox aims to promote compliance and formulate a fit-for-purpose and risk-based regulatory regime. 

Hong Kong’s Consultation Conclusions, Sandbox and the upcoming FRS regulatory regime are key steps towards ensuring “stable” stablecoins live up to their name![5]

[1] Stablecoins are a class of virtual asset that aim to maintain a stable value with reference to certain asset(s), typically fiat currencies.

[2] A total of 108 submissions were received in response to the Consultation Paper.

[3] “Decentralised distributed ledger” refers to a distributed ledger in which no person has the unilateral authority to control or materially alter its functionality or operation.

[4]  “Passporting” refers to a system where an entity licensed in one jurisdiction (e.g. Hong Kong) can operate in comparable jurisdictions without the need for a local license. 

[5] The crypto events of 2022, including the demise of the TerraUSD/LUNA coins and the de-pegging of a number of so-called stablecoins, highlighted the need for appropriate and comprehensive regulation and supervision worldwide.