The proposed regulatory framework would create substantive obligations on issuers of fiat-referencing stablecoins to safeguard the public.
On 27 December 2023, the Financial Services and the Treasury Bureau (FSTB) and the Hong Kong Monetary Authority (HKMA) released a consultation paper on their legislative proposal for a regulatory regime governing stablecoin issuers in Hong Kong (Consultation Paper). The HKMA followed with its own press release announcing a future sandbox arrangement for stablecoin issuers.
This blog post summarises the proposed Hong Kong regulatory framework set out in the Consultation Paper, and next steps for stablecoin issuers who may fall within scope of the proposed regime.
The Consultation Paper follows the discussion paper released by the HKMA in January 2022 (Discussion Paper) seeking the public’s views on its proposed approach to the regulation of stablecoins (see Latham’s blog post), and its conclusions issued in January 2023 (Discussion Conclusions). The Discussion Paper received responses from a wide variety of stakeholders, including industry bodies, crypto native firms, and banks, and the HKMA announced in the Discussion Conclusions that it would propose a risk-based regulatory framework for fiat-referencing stablecoins (FRS), with further consultation in due course. The Consultation Paper now sets out detailed proposals of how stablecoin issuers should be regulated in Hong Kong.
The Consultation Paper follows international developments in other jurisdictions, in which regimes to regulate global stablecoin arrangements are being implemented with reference to recommendations, standards, and guidance issued by international standard-setting bodies such as the Financial Stability Board.
In August 2023, the Monetary Authority of Singapore announced its own stablecoin regulatory framework, which introduces licensing and other requirements for stablecoin issuers with operations in Singapore (see Latham’s blog post). In November 2023, the Bank of England, the Financial Conduct Authority, and the Prudential Regulation Authority issued discussion papers and guidance setting out their proposed regulatory framework for stablecoin issuers, related payment systems, and service providers.
How Stablecoins Are Currently Regulated in Hong Kong
Currently, there is no specific regulatory framework governing stablecoin issuers or stablecoins in Hong Kong.
Under existing Hong Kong laws, stablecoin arrangements could potentially fall within the definition of a “stored value facility” (SVF) under the Payment Systems and Stored Value Facilities Ordinance (PSSVFO) and be subject to applicable licensing requirements, depending on how the stablecoin arrangements are structured. However, the SVF regime is designed to create a licensing regime for electronic facilities such as e-wallets and prepaid cards. Given the decentralised nature of cryptocurrency, many global stablecoins arrangements do not neatly fall within the strict definition in the PSSVFO.
Other existing regulatory frameworks, such as under the Securities and Futures Ordinance (which covers securities, collective investment schemes, and structured products), also do not properly capture fiat-referencing stablecoins, which are designed to be payment instruments rather than investments.
Proposed Regulatory Approach to Stablecoin Issuers
In view of the regulatory gap, the Consultation Paper proposes a new regulatory framework tailored specifically to FRS issuers in Hong Kong, to be supervised by the HKMA.
This new standalone regime would apply equally, so that all FRS issuers would require a licence (irrespective of whether the FRS issuer is an existing bank or not). However, certain requirements, as indicated below, would not apply to FRS issuers that are HKMA-authorised institutions (AI) (e.g., licensed banks) in Hong Kong since they are already subject to prudential and ongoing holistic supervision by the HKMA.
The key aspects of the proposed regulatory regime are as follows:
- FRS would be covered. FRS are cryptographically secured digital representations of value that (i) are expressed as a unit of account or store of economic value, (ii) are intended to be used as a medium of exchange, (iii) are electronically transferable on a distributed ledger (not solely controlled by the issuer), and (iv) purport to maintain a stable value to one or more fiat currencies.
The definition would capture FRS irrespective of the manner of stabilisation, i.e., it would cover stablecoins that derive their value from arbitrage or algorithmic stabilization, but an issuer of FRS with these types of stabilisation mechanisms would effectively be unable to obtain a licence as the HKMA would unlikely approve such an FRS issuer in view of the proposed licensing requirements summarised below.
Certain financial instruments such as deposits, securities or futures contracts, SVFs, central bank digital currency, and limited-purpose digital currency would be exempt from the regime. The HKMA would also receive powers to adjust the parameters of in-scope stablecoins and activities in line with market developments and emerging risks.
- FRS issuers would be regulated and licensed. All FRS issuers that: (i) issue FRS in Hong Kong, (ii) issue a stablecoin referencing the Hong Kong dollar, or (iii) “actively market” the issuance of FRS to the Hong Kong public, would require a licence with the HKMA. The licence would be open-ended (i.e., remain valid unless revoked by the HKMA).
“Active marketing” may include frequently calling on members of the Hong Kong public and marketing their services, running a mass media programme targeting the Hong Kong public, and internet activities that target the Hong Kong public.
- New legislation would be introduced. New legislation would be introduced to regulate FRS issuers, which could potentially be expanded to cover new virtual asset activities in the future. To avoid overlap with existing regimes, licensed FRS issuers would be excluded from the existing regimes, such as for securities and SVFs.
- Full backing with high-quality, segregated assets. FRS issuers would be subject to reserve and stabilisation mechanism requirements. The value of the reserve assets backing an FRS must be at least equal to the par value of the FRS in circulation at all times. The investment policy (backed up by proper risk management and internal controls) must ensure that the reserve assets are of high quality and high liquidity and held in the reference currency, unless the HKMA approves otherwise. The reserve assets would need to be segregated from proprietary assets and held with licensed banks or other approved asset custodians.
- Regular disclosure, auditing, reporting, and attestation of the FRS arrangements. The total amount of the FRS in circulation, the mark-to-market value of reserve assets, and the composition of reserve assets must be disclosed regularly to the general public. A qualified and independent auditor would be required to perform regular attestation. The total amount of FRS in circulation and the value of reserve assets would be disclosed at least daily, the composition of reserve assets be disclosed at least weekly, and attestation by the independent auditor be performed at least monthly.
Separately, the FRS issuer would need to submit audited financial statements to the HKMA on an annual basis and as required by the HKMA.
- Prohibition on paying interest. Any income or loss from the reserve assets (e.g., interest payments, dividends, or capital gains or losses) would be attributed to the FRS issuer. FRS issuers would not be permitted to pay interest to its users.
- Responsibility for effective stabilisation. The FRS issuer would be ultimately responsible for ensuring the effective functioning of the stabilisation mechanism of the FRS it issues, even in the case of any outsourcing to third parties.
- Orderly and fair redemption process. 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. The FRS issuer would need to process the redemption requests in a timely manner without undue costs, and put in place appropriate contingency plans to ensure processing availability at all times.
- No other financial services and business activities (not applicable to licensed banks, restricted licence banks, and deposit-taking companies, known as AIs). Unless approved by the HKMA, FRS issuers would not be able to conduct other securities, lending, and other financial activities. An FRS issuer would be permitted to conduct activities that are ancillary or incidental to its issuance of FRS (e.g., providing wallet services for the FRS).
- Physical presence and incorporation in Hong Kong (not applicable to AIs). The FRS issuer would need to be a company incorporated in Hong Kong and have a registered office in Hong Kong. Its chief executive, senior management team, and key personnel must be based in Hong Kong and exercise effective management and control of its FRS issuance and related activities.
- Financial resources requirements (not applicable to AIs). The FRS issuer would require a minimum paid-up share capital of either HK$25,000,000 or a fixed percentage of the par value of FRS in circulation, whichever is higher (proposed at 2%).
- Publication of white paper. The FRS issuer would need to publish a white paper to disclose general information about itself, the rights and obligations of the FRS users, the redemption terms, the FRS stabilisation mechanism, reserves management arrangements, the underlying technology, and the risks.
- Governance and risk management requirements would be imposed. The FRS issuer would need to have appropriate senior management, risk management, and anti-money laundering / counter-financing of terrorism controls (including for conducting customer due diligence and complying with the travel rule) for its operations. Controllers, chief executives, and directors of an FRS issuer must be fit and proper persons and would need to be approved by the HKMA.
- Standard supervisory powers granted to the HKMA. The HKMA would have wide-ranging supervisory powers over the FRS issuer, including to gather information, give directions, impose licensing conditions, make regulations, and investigate non-compliance. Failure to comply with the new legal and regulatory framework will give rise to criminal and/or civil penalties.
Restrictions on Hong Kong-Licensed Intermediaries Offering FRS
To ensure that the Hong Kong public is protected, the Consultation Paper proposes that only certain Hong Kong-licensed entities, i.e., licensed FRS issuers, banks, securities firms, and trading platforms can offer FRS in Hong Kong or actively market such offering to the public of Hong Kong.
FRS that were issued by non-HKMA-licensed FRS issuers would only be permitted to be offered to “professional investors” (e.g., high-net-worth individuals with a portfolio of at least HK$8 million (around US$1 million), corporations with portfolios of at least HK$8 million or total assets of at least HK$40 million (around US$5.16 million), or institutional investors), and there must be clear indication such FRS is not issued by a HKMA-licensed FRS issuer.
The commencement date of the regime is proposed to be one month upon gazettal of the proposed new legislation. On commencement, FRS issuers falling within the scope of the regime would require a licence issued by the HKMA. The provisions on offering of FRS and the restrictions relating to issuing advertisements of FRS would also become effective at the same time.
To facilitate a smooth transition, pre-existing FRS issuers that are already conducting FRS issuance activities with meaningful and substantial presence in Hong Kong (e.g., an entity operating the FRS issuance that is incorporated or has a physical presence in Hong Kong, with staff exercising central management and control) prior to the commencement date could continue to operate under a non-contravention period of six months if they submit a licence application to the HKMA within the first three months of the commencement of the regulatory regime.
Pre-existing FRS issuers that do not submit a licence application to the HKMA within the first three months of the commencement date would need to close down their business in an orderly manner no later than four months after the commencement date.
The HKMA also announced that it will introduce a sandbox arrangement so that entities having a genuine interest in, and a reasonable plan on, issuing FRS in Hong Kong can receive additional guidance from the HKMA, and the HKMA can obtain feedback on its proposed regulatory regime. Relevant details of the sandbox arrangement will be announced separately.
Comments to the proposals set out in the Consultation Paper should be submitted on or before 29 February 2024.
As the HKMA has already consulted the industry previously, we would not expect major deviations to the proposals set out in the Consultation Paper. While many of the proposed regulatory requirements are expected and consistent with other jurisdictions, the requirement for local incorporation of the FRS issuer (for non-AIs) will cause some concern, since the issuers of major stablecoins in the market are not incorporated in Hong Kong.
Since any new legislation will need to pass through the Hong Kong Legislative Council before it is enacted, market participants will receive a further opportunity to comment on the proposed wording of the legislation. As of now, no draft legislation or proposed regulatory rules have been released.
In passing, the Consultation Paper also noted that the FSTB, the HKMA, and the Securities and Futures Commission are looking into the potential regulation of virtual asset custody and offering services under dedicated guardrails.
Existing FRS issuers should consider whether they may fall within scope of the licensing framework, the extent of their active marketing and user base in Hong Kong, and whether they may want to enter the sandbox arrangement to be announced by the HKMA.
Latham & Watkins will continue to analyse and report on the new developments to the proposed Hong Kong stablecoin regulatory framework.