Stablecoins to be regulated

The HKMA intends to focus on regulating stablecoins that purport to reference one or more fiat currencies.

Any stablecoin that does so will be captured by the regulatory scope regardless of that stablecoin’s underlying stabilisation mechanism and/or predominant uses. Thus, stablecoins that purport to reference fiat currencies through algorithms or arbitrage mechanisms in principle fall within the Proposed HK Framework (although practically, entities carrying on activities in relation to such stablecoins are less likely to be accepted for licensing, as further outlined below). Likewise, stablecoins used predominantly for wholesale or crypto-asset transactions fall within the Proposed HK Framework so long as they purport to reference fiat currencies.

Non-fiat referencing stablecoins are not entirely off the hook as the Proposed HK Framework allows the HKMA to incorporate other types of stablecoin structures into the regulatory regime should the need arise. Further guidance setting out factors that the HKMA would consider in deciding whether a particular stablecoin will be subject to regulation is likely to follow. In this regard, a relevant consideration may be whether the stablecoin has been (or will likely be) used in payments and whether it has linkages with the traditional finance system, thereby giving rise to imminent monetary and financial stability risks.

While not set in stone, it appears that tokenised deposits along with certain specific arrangements (e.g., arrangements already subject to another financial regulatory regime or used within a confined sandbox) will be excluded from the Proposed HK Framework. The precise scope of these exclusions will, however, only be determined after further consultation.

Regulated activities

The following activities will also be regulated where they relate to stablecoins that fall within the Proposed HK Framework:

(a) Establishment and maintenance of the rules governing the stablecoin arrangement (Governance)

(b) Issuance, creation or destruction of the stablecoin (Issuance)

(c) Stabilisation and reserve management of the stablecoin, whether by the issuer or another party (Stabilisation)

(d) Provision of services that allow storage of users’ cryptographic keys enabling access to their holding and management of the stablecoin (Wallets)

This list is non-exhaustive, and the HKMA may expand it to cover more stablecoin-related activities when the regime is finalised. The Proposed HK Framework will also allow the HKMA to define new types of regulated activities in the future should the need arise.

However, the HKMA suggests that, at least at the initial stage, certain activities may not fall within the regulatory scope. This might include purchasing or exchanging a stablecoin with fiat currency, operation and management of centralised stablecoin lending services, issuance of crypto-asset debit/credit cards, and operation of crypto-asset automated teller machines or exchange shops.

It should also be noted that entities which fall within the Proposed HK Framework cannot evade liability through outsourcing as they will be expected to retain ultimate control of outsourced regulated activities.

Authorisation and regulatory requirements

While the precise details of the regulatory regime remain to be formulated, several points of note can be gleaned from the Conclusion.

First, the Proposed HK Framework will not introduce a single licence that covers all regulated activities. Instead, each regulated activity will have specific licences and regulatory requirements. This offers the prospect of targeted (potentially less burdensome) licensing requirements for entities conducting fewer stablecoin activities, such as payment providers which offer wallet services.

Second, these regulatory requirements will cover a range of areas including (but not limited to):

(a) Ownership

(b) Governance and management

(c) Financial resources

(d) Risk management

(e) AML/CFT

(f) User protection

(g) Audit and disclosure

Third, stablecoins falling within the Proposed HK Framework will have to be fully backed and redeemable at par into their referenced fiat currency by holders within a reasonable period. There should, at all times, be sufficient reserve assets to meet the value of all outstanding stablecoins. In addition, reserve assets should be of high quality and liquidity. Accordingly, while stablecoins that derive their value from arbitrage or algorithms are in principle within scope of the Proposed HK Framework, the HKMA appears unlikely to grant a licence for entities carrying on activities relating to such stablecoins.

Fourth, entities falling within the Proposed HK Framework will be restricted from conducting activities that deviate from their principal business as permitted under the relevant licence (e.g., wallet operators will not be allowed to engage in lending activities). However, authorised institutions (AIs) that are already subject to similar or more stringent regulatory requirements with respect to their deposit-taking businesses will be exempted from this restriction should they fall within the Proposed HK Framework.

Fifth, the HKMA will adopt a flexible “same risk, same regulation” approach whereby both AIs and non-AIs will be allowed to issue stablecoins so long as they can satisfy the relevant regulatory requirements. The HKMA will also calibrate the final regulatory requirements applicable to a particular entity according to the risks presented to the financial system, the specific stablecoin arrangement in question and all other relevant factors.

Finally, the HKMA is considering imposing a local incorporation requirement on entities which fall within the Proposed HK Framework. However, while the HKMA takes the view that such a requirement is “highly conducive” to effective supervision, this requirement remains subject to further evaluation and is not yet final.

Who will require a licence?

Any entity conducting a regulated activity in Hong Kong, or “actively marketing” such an activity to the Hong Kong public, will be required to be licensed.

On top of that, any entity engaging in regulated activities in relation to a stablecoin that purports to reference its value to the Hong Kong dollar will need to obtain a relevant licence regardless of whether the regulated activity is conducted in Hong Kong and whether there has been active marketing to the general public in Hong Kong.

Finally, the HKMA will retain the power to scope in entities which fall outside the existing regulatory regime on grounds of public interest.

When and how will the Proposed HK Framework be implemented?

The HKMA has signalled its intention to put in place the Proposed HK Framework by 2023/24.

With regard to the method of implementation, the HKMA is considering either amending the Payment Systems and Stored Value Facilities Ordinance (PSSVFO) or introducing new, standalone legislation.

Future expansion of the Proposed HK Framework

While the Proposed HK Framework focuses on stablecoins, the HKMA has indicated that it will consider international developments in deciding whether the Proposed HK Framework should be expanded to include other crypto-assets. Additional consultations as to whether new legislation should be introduced to regulate relevant segments of the crypto-asset market will also be conducted.

Commentary

Like fellow Asian financial hub, Singapore, Hong Kong has chosen to focus on stablecoins given their potential to affect the wider crypto sector and financial system. The following section provides a broad comparison of each jurisdiction’s proposed framework for regulating stablecoins.

Type of stablecoins captured

The Proposed HK Framework appears to be more far-reaching than the MAS’ proposed regulatory framework (the Proposed SG Framework).

While the MAS intends to focus on single-currency pegged stablecoins (SCS), the Proposed HK Framework is more all-encompassing as it captures stablecoins that purport to reference one or more fiat currencies. In addition, while the MAS has ruled out regulating algorithmically pegged stablecoins, the Proposed HK Framework in principle captures stablecoins that reference fiat currencies “through algorithm or arbitrage mechanisms” (although practically, such stablecoins may not meet the eligibility requirements for the Proposed HK Framework).

Types of activities regulated

The Proposed HK Framework covers a wider range of activities than its Singaporean counterpart.

While the MAS has only proposed to regulate SCS issuers (i.e., entities based in Singapore that perform the function of controlling the total supply of, and the minting and burning of, SCS), the Proposed HK Framework will capture all entities that engage in regulated activities in Hong Kong.

Pertinently, the Proposed HK Framework captures wallet providers who allow users to store cryptographic keys enabling access to their stablecoins (insofar as those stablecoins fall within the Proposed HK Framework). If the HKMA follows through with these plans, there may be a significant impact on digital asset custodians, as a separate licence specific to stablecoins may be required.

Extraterritorial impact

Unlike the Proposed SG Framework, the Proposed HK Framework will likely have an extraterritorial impact.

The HKMA has signalled its intention to regulate any entity which engages in regulated activities in relation to Hong Kong dollar-referencing stablecoins regardless of where that regulated activity is conducted and regardless of whether there was active marketing in Hong Kong. In contrast, the MAS’s immediate priority is to regulate SCS issued in Singapore. Thus, while it may not be possible to issue Hong Kong dollar-referencing stablecoins outside of Hong Kong without a licence once the Proposed HK Framework is implemented, the same cannot be said for their Singapore dollar-referencing equivalent.

Key regulatory principles

Both the Proposed HK Framework and Proposed SG Framework require regulated stablecoins to be fully backed and redeemable at par by holders within a reasonable time. Both frameworks are also set to include business restrictions on regulated entities (e.g., under the Proposed SG Framework, an SCS issuer is restricted from engaging in other activities that introduce additional risks to itself).

Conclusion

As the crypto sector increasingly experiences a race towards regulation and industry participants increasingly wish to be supervised in a reputable jurisdiction, the Proposed HK Framework and Proposed SG Framework may both, over time, prove attractive to stakeholders in the stablecoin space.

It has therefore become all the more strategically important for VASPs looking to operate in or market to these jurisdictions to be aware of the likely scope of regulations and impact upon business.

Should you have questions on any of the above, please contact the authors.

In-depth 2023-047