The HKMA’s discussion paper seeks feedback on its proposed regulatory approach to stablecoins, with responses due by 31 March 2022.
By Simon Hawkins and Adrian Fong
On 12 January 2022, the Hong Kong Monetary Authority (HKMA), Hong Kong’s principal regulator for banks and payment systems, published a discussion paper seeking the public’s views on its proposed approach to the regulation of stablecoins (Discussion Paper). The HKMA outlines its views on the development of stablecoins and proposes questions and its initial outlook for establishing an effective regulatory framework for stablecoin activities in Hong Kong.
The Discussion Paper comes three months after the HKMA issued its technical whitepaper on retail central bank digital currency in October 2021, which considers a proposed architecture for issuing e-HKD. These publications, together with recent consultation conclusions from the Financial Services and the Treasury Bureau on implementing a regulatory regime for virtual asset service providers, (see Latham’s blog post), indicate that Hong Kong regulators are moving quickly to create guardrails as financial innovation accelerates.
What are stablecoins?
Stablecoins are blockchain-based tokens that attempt to maintain a stable value by reference to an underlying fiat currency or a basket of assets. The use of stablecoins has risen sharply from less than US$3 billion in market capitalisation at the beginning of 2019 to approximately US$150 billion in December 2021. Stablecoins are important to the cryptoasset ecosystem because they function as an intermediary token, which can be used between cryptocurrency intermediaries and allows users to avoid cashing out their investments into a bank account.
In the Discussion Paper, the HKMA divides stablecoins into two categories based on their backing arrangements:
(i) Asset-linked stablecoins linked to e.g., fiat currencies, commodities, or other financial assets
(ii) Algorithm-based stablecoins that use other means to maintain a stable value, usually via protocols that provide for changes in the supply of stablecoins in response to changes in demand
The HKMA also distinguishes between stablecoins used for investment purposes (investment-related stablecoins) and those used for payment purposes (payment-related stablecoins).
The rapid growth of cryptocurrencies and, in particular, stablecoins pegged to traditional currencies, has drawn attention from regulators and standard-setting bodies worldwide. The Financial Stability Board (FSB) published its report on Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements in October 2020, which outlined certain recommendations to mitigate the risks created by global stablecoins. Other international bodies, such as the Basel Committee on Banking Supervision, the Committee on Payments and Market Infrastructures, and the International Organization of Securities Commissions, have also published discussion papers and guidance related to cryptoasset and stablecoin arrangements.
HKMA’s proposed regulatory approach
One of the HKMA’s primary functions is ensuring the stability and integrity of the Hong Kong financial system, including the banking and payment system. In particular, it has existing powers under the Payment Systems and Stored Value Facilities Ordinance (Cap. 584, Laws of Hong Kong) (PSSVFO) to regulate retail payment systems and stored value facilities.
The HKMA notes that stablecoins could potentially fall within the definition of a “stored value facility” (SVF) under the PSSVFO (and be subject to applicable licensing requirements), depending on how the stablecoin arrangements are structured. However, given the decentralised nature of current stablecoins — which are structured so that different entities take on the role of stablecoin issuer and wallet provider — many stablecoins may fall outside the strict definition in the PSSVFO and therefore outside the HKMA’s regulatory perimeter.
In light of the perceived risks from the growing prevalence of stablecoins, the HKMA sees the need to expand its regulatory framework to ensure that stablecoins, particularly payment-related stablecoins, are appropriately regulated before they operate in or are marketed to the public in Hong Kong. The Discussion Paper builds on the FSB’s recommendations and sets a potential path for regulating stablecoins in Hong Kong.
The HKMA is clear that there is a strong need to regulate stablecoins. The regulator is not asking stakeholders whether it should be done, but is instead asking for feedback on the regime’s regulatory scope.
In terms of the objectives and guiding principles, the HKMA considers that the regime should ensure monetary and financial stability, protect users, and minimise the risk of regulatory arbitrage. The regime should also be agile, risk-based, and proportionate so as to allow room for financial innovation.
The HKMA raises the following eight discussion questions, along with its views:
Q1. Should we regulate activities relating to all types of stablecoins or give priority to those payment-related stablecoins that pose higher risks to the monetary and financial systems, while providing flexibility in the regime to make adjustments to the scope of stablecoins that may be subject to regulation as needed in the future?
The HKMA suggests that it should adopt a risk-based approach to focus on regulating activities connected to payment-related stablecoins, and in particular, asset-linked stablecoins (e.g., linked to a single fiat currency), as they have a higher potential to be incorporated into the mainstream financial system and therefore pose a more immediate risk than other types of stablecoin.
However, the HKMA does not rule out the possibility of regulating other types of stablecoins (e.g., algorithm-based stablecoins), and the regulatory regime likely will be developed to be flexible and responsive to further policy and market developments over time.
Q2. What types of stablecoin-related activities should fall under the regulatory ambit, e.g., issuance and redemption, custody and administration, reserves management?
The HKMA proposes that persons involved in the following (non-exhaustive) list of activities would all need to be HKMA-licensed (the Stablecoins Activities):
- Issuing, creating, and destroying (i.e., burning or removing from circulation) stablecoins
- Managing reserve assets to ensure stabilisation of the stablecoin value
- Authorising or verifying the validity of transactions and records
- Storing private keys to provide access to stablecoins
- Facilitating the redemption of stablecoins for fiat currency and other assets
- Ensuring settlement of transactions and transmission of funds
- Executing transactions on behalf of others
Given that a stablecoin arrangement generally involves more than one entity, the HKMA notes that multiple entities involved in a stablecoin arrangement may be required to seek authorisation from the HKMA. Depending on the requirements, this could create a material compliance burden if multiple entities need to be licensed under the new regime.
The HKMA intends to implement the licensing requirement either by expanding the scope of the PSSVFO or by introducing new legislation. Both options will require a significant amount of work by the HKMA and there likely will be a number of future consultations on the detailed requirements of the new regulatory regime. The regulatory regime will also likely be shaped by international standards and policy on stablecoins, as this is an area of continued focus for the FSB and other international bodies.
Q3. What kind of authorisation and regulatory requirements would be envisaged for those entities subject to the new licensing regime?
Depending on the types of services offered, the HKMA proposes that persons carrying on the Stablecoin Activities will need to meet the following standards and requirements, which will be applied using a risk-based approach:
- Minimum authorisation requirements to obtain a licence from the HKMA
- Prudential requirements to have adequate and effective management of capital and liquidity
- Fit and proper requirements on management and controllers
- Maintenance and management requirements for reserves of backing assets, including sufficient and adequate assets backing the stablecoin
- Systems, controls, governance, and risk management requirements to manage legal, credit, liquidity, operational, anti-money laundering/counter-terrorist financing (AML/CFT), and other risks
- AML/CFT requirements for implementing and applying AML/CFT rules and principles
- Redemption requirements to ensure processes around how stablecoins can be redeemed
- Financial reporting and disclosure to the regulators and users
- Safety, efficiency, and security requirements to protect against cybersecurity, operational, and business continuity-type risks
- Settlement finality such that there is clear and final settlement regardless of the operational settlement method used
These proposed requirements are consistent with regulatory expectations for other licensees under the PSSVFO and banking legislation; the devil will be in the detail of these requirements, particularly those relating to capital and liquidity, AML/CFT, cybersecurity, and settlement finality.
Q4. What is the intended coverage as to who needs a licence under the intended regulatory regime?
The HKMA proposes that any person who carries out Stablecoins Activities in Hong Kong, or actively markets to the Hong Kong public such activities as a business, must be licensed by the HKMA. Only an company incorporated in Hong Kong (as opposed to a “branch”) will be eligible for a licence from the HKMA. A foreign company or group would need to incorporate a company under Hong Kong law and use that entity to apply to the HKMA for a licence.
The proposed requirement for the establishment of a local entity is also not surprising, but could prove controversial as it would represent a departure from the typical structure of many companies that currently provide Stablecoin Activities on an international, cross-border basis.
Q5. When will this new, risk-based regime on stablecoins be established, and would there be regulatory overlap with other financial regulatory regimes in Hong Kong, including but not limited to the Securities and Futures Commission’s virtual asset service provider regime, and the SVF licensing regime of the PSSVFO?
The HKMA will assess feedback and consider the need to issue further documents on specific aspects of the regulatory framework in 2022/23. It aims to introduce the new regime no later than 2023/24.
The HKMA is conscious of the need to work closely with other government stakeholders and financial regulators to identify areas for coordination and to avoid regulatory arbitrage. This is important as there are multiple financial regulatory regimes in Hong Kong (administered by different regulators), which creates potential for overlap.
Q6. Stablecoins could be subject to run risk and become potential substitutes of bank deposits. Should the HKMA require stablecoin issuers to be authorised institutions (AIs) under the Banking Ordinance, similar to the recommendations in the Report on Stablecoins issued by the US President’s Working Group on Financial Markets?
The HKMA will draw reference from the relevant international standards and guidance. The HKMA’s proposed approach is to regulate stablecoin arrangements similar to SVFs, which should reduce the regulatory arbitrage and ensure similar high prudential requirements (e.g., in terms of capital and liquidity requirements).
Q7. Would the HKMA also plan to regulate unbacked cryptoassets given their growing links to the mainstream financial system and risk to financial stability?
The HKMA will continue to monitor the development of cryptoassets alongside other regulators in Hong Kong, and take action as needed to ensure financial stability and avoid regulatory arbitrage. It will be particularly important for the HKMA to set the perimeter of regulatory regime for stablecoins in such a way that it does not overlap with the SFC’s forthcoming regime for virtual asset exchanges and any future legislation to regulate other types of virtual asset service provider businesses.
Q8. For current or prospective parties and entities in the stablecoins ecosystem, what should they do before the HKMA’s regulatory regime is introduced?
Interested parties are encouraged to respond to the Discussion Paper by 31 March 2022, in line with the HKMA’s aim to introduce the new regime no later than 2023/24. Notably, a number of industry bodies are actively preparing responses to the Discussion Paper.
Stakeholders should consider the Discussion Paper and provide responses to the points raised by 31 March 2022.
The HKMA has noted that it will continue to supervise banks’ activities in relation to cryptoassets and implement the SVF licensing regime according to the current supervisory powers and policies. It will also soon provide banks with more detailed regulatory guidance in relation to the banks’ business interface with and provision of intermediary services to customers related to cryptoassets.
Latham & Watkins will continue to analyse and report on the proposed regime.
The authors would like to thank Shirley Wong in the Hong Kong office of Latham & Watkins for her contribution to this blog post.
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