Proposed Regulatory Regime for Stablecoin Issuers in Hong Kong

In response to the growing prominence of stablecoins and their potential impact on financial systems, the Financial Services and the Treasury Bureau (FSTB) and the Hong Kong Monetary Authority (HKMA) have introduced a comprehensive regulatory proposal for stablecoin issuers in Hong Kong. 

This article covers the key aspects of this proposal, from the definition and scope of fiat-referenced stablecoins (FRS) to the detailed regulatory requirements that issuers must meet. It also examines how these regulations align with international standards and discusses the implications for both domestic and foreign issuers, ensuring a thorough understanding of the proposed regime.

Hong Kong: Regulatory Context

After the Legislative Council passed the Anti-Money Laundering and Counter-Terrorist Financing (Amendment) Bill 2022 in December 2022, a new licensing regime for virtual asset service providers (VASPs) was established under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance. This regime, which came into effect on June 1, 2023, mandates that centralized virtual asset exchanges operating in Hong Kong must be licensed and regulated by the Securities and Futures Commission (SFC).

On December 27, 2023, the Financial Services and the Treasury Bureau (FSTB) and the Hong Kong Monetary Authority (HKMA) jointly released a consultation paper regarding a proposed regulatory framework for stablecoin issuers in Hong Kong. This consultation period lasted for two months, concluding on February 29, 2024, and received a total of 108 submissions from a diverse group of respondents, including market participants, industry associations, business and professional organizations, and individuals.

On July 17, 2024, the FSTB and HKMA published the consultation conclusions on the legislative proposal to implement a regulatory regime for fiat-referenced stablecoin (FRS) issuers in Hong Kong. This proposed licensing regime for FRS issuers will complement the existing regulatory framework for virtual asset (VA) trading platforms, enhancing Hong Kong's VA regulatory structure to align with international standards and effectively mitigate potential financial stability risks related to FRS issuance activities.

Scope of Proposal: Regulated Assets and Activities

Stablecoin: Regulatory Definition

Under the proposal, a stablecoin is defined as a cryptographically secured digital representation of value with several key features that, among other things: 

• is expressed as a unit of account or a store of economic value;
• is used, or is intended to be used, as a medium of exchange accepted by the public, for the purpose of payment for goods or services; discharge of a debt; and/or investment;
• can be transferred, stored or traded electronically; 
• uses a decentralized distributed ledger or similar technology that is not controlled solely by the issuer; and 
• purports to maintain a stable value with reference to a specified asset, or a pool or basket of assets.

The definition of stablecoins proposed by Hong Kong is largely consistent with those suggested by international standard setters like CPMI and IOSCO. According to CPMI and IOSCO, a stablecoin is an arrangement that combines various functions to create an instrument intended for use as a means of payment and/or a store of value. 

The IMF describes stablecoins as crypto assets, either centrally or decentrally issued, that aim to maintain a stable price through the use of reserve assets or algorithms that adjust to changes in demand and supply. These stablecoins are typically denominated in a standard monetary unit, such as the dollar, and may promise to redeem into cash at par value. 

The FSB defines stablecoins as a category of crypto assets designed to maintain a stable value relative to a specific asset or a basket of assets, providing perceived stability in contrast to the high volatility of unbacked crypto assets.

Scope: Fiat-Referenced Stablecoins (FRS)

The HKMA and FSTB plan to regulate fiat-referencing stablecoins (FRS), which are stablecoins pegged to one or more fiat currencies. The primary reason for focusing on FRS regulation is their potential to become widely accepted as a means of payment, posing more immediate monetary and financial stability risks compared to other virtual assets or stablecoins, such as commodity-referenced stablecoins. Consequently, the FSTB and HKMA propose that issuing an FRS should be considered a regulated stablecoin activity under the new legislation. This aligns with BIS 2024 insights, indicating that certain types of stablecoins have a higher potential for use as a means of payment than others. Among all stablecoin types, those pegged to fiat currencies have the greatest potential for being used as a means of payment.

Similar to Hong Kong, the UK Government intends to prioritize fiat-backed stablecoins in the initial phase of its crypto asset regulation. Fiat-backed stablecoins are designed to maintain a stable value by being linked to, and potentially holding, one or more specified fiat currencies. In contrast, the EU's Markets in Crypto-Assets Regulation (MiCAR) covers a broader spectrum of stablecoins, including those pegged to other assets like commodities or other crypto assets.

Scope: Algorithmic FRS

Under the proposed regulatory regime, all FRS issuers will receive the same regulatory treatment, regardless of the stabilization mechanism or underlying backing assets of the FRS. For example, an issuer of an FRS that derives its value from arbitrage or algorithmic mechanisms will fall within the regulatory scope. However, it is highly unlikely that such an issuer will meet the proposed licensing criteria, particularly regarding reserves management, and thus be able to obtain a license.

Similarly, the EU MiCAR applies to EMTs (E-Money Tokens) and ARTs (Asset-Referenced Tokens), irrespective of how the issuer intends to design the crypto-asset, including the mechanism for maintaining a stable value of the crypto-asset.  The same applies to so-called algorithmic ‘stablecoins’ that aim to maintain a stable value in relation to an official currency, or in relation to one or several assets, via protocols, that provide for the increase or decrease in the supply of such crypto-assets in response to changes in demand. The MiCAR definition of E-Money Tokens does not distinguish between different methods of maintaining a stable value. As a result, EMTs can be either collateralized or utilize an algorithmic mechanism.

Scope: Exclusions

The proposal currently excludes other types of stablecoins, such as commodity-linked stablecoins. However, the scope may be expanded in the future to include other types of stablecoins not covered by the current FRS proposal.

It is proposed that the following should NOT be classified as "stablecoins": 

• deposits (including their tokenized or digitally represented forms); 
• certain securities or futures contracts (primarily authorized collective investment schemes and authorized structured products); 
• funds stored in stored value facilities (SVFs) or SVF deposits; 
• digital representations of fiat currencies issued by or on behalf of central banks (CBDCs); and
• certain digital representations of value that serve a limited purpose.

Regulated Activity: Issuance

The current proposal focuses solely on issuance activities. However, the Government and financial regulators are currently exploring the regulatory approach for FRS-related activities and will engage the public and relevant stakeholders throughout the process.

The FRS issuer may issue multiple FRSs under their current license without needing to establish a separate entity or undergo an additional application process. However, the issuer must explain the rationale, justify the use cases, and obtain prior consent from the Monetary Authority (MA) before issuing a new FRS.

For comparison, the UK Treasury’s Policy Statement introduces two new activities. The first activity is the issuance of regulated stablecoins, which pertains to the issuance of stablecoins within or from the UK. The second activity involves custody activities, which include safeguarding regulated stablecoins and crypto assets that qualify as specified investments, such as security tokens.

Scope of Proposal: Issuers

General Rule: Licensing

Most global regulations adhere to two types of licensing frameworks. The first framework permits certain regulated financial institutions, including banks and non-bank financial institutions, to issue stablecoins. The second framework establishes a new category of regulated entities authorized to issue stablecoins after acquiring a crypto-specific license. Hong Kong is adopting the latter approach.

Under the proposed licensing regime, no person is allowed to:

• Issue FRS in Hong Kong: Issue or present themselves as issuing an FRS in Hong Kong.
• Issue Stablecoins Pegged to HKD: Issue or present themselves as issuing a stablecoin that claims to maintain a stable value relative to the Hong Kong dollar.
• Market FRS to the Public: Actively market the issuance of FRS to the public in Hong Kong.

These activities are prohibited unless the entity holds an FRS issuer license granted by the Monetary Authority (MA).

FRS Issuers: Domestic

Under the proposed regulatory regime, any person issuing fiat-referenced stablecoins (FRS) in Hong Kong will be required to obtain a license from the MA.

Determining whether an FRS is issued in Hong Kong will be based on the specific facts and circumstances of each case. Factors to be considered include:

• the issuer’s place of incorporation, 
• the location of its operations, 
• the provision of subsequent customer service to FRS users, and 
• whether a Hong Kong bank account is used to process issuance and redemption requests.

FRS Issuers: Foreign

For foreign entities, it is necessary to establish a physical presence for the FRS issuing entity and have key personnel based in Hong Kong to ensure the HKMA can maintain effective regulatory oversight. Non-Hong Kong incorporated companies will be required to set up a subsidiary in Hong Kong if they wish to apply for a license. In the future, Hong Kong authorities will evaluate the potential benefits of establishing mutual recognition agreements (“regulatory equivalence”) with comparable jurisdictions, as this could contribute to the sustainable development of the virtual asset ecosystem

Similarly, under the EU MiCAR, a foreign entity must establish a physical presence and an effective place of management in the EU, including having directors located there, to provide services to EU clientele. Foreign entities can leverage the narrow exemption of reverse solicitation if the service is requested by the client on their own initiative. The feasibility of implementing equivalence regulatory arrangements will be reviewed in future.

For comparison, under the UK proposal, the Treasury is considering regulations for the use of overseas stablecoins within UK payment systems. This includes the possibility that such stablecoins might need to be approved by an authorized 'payment arranger' before they can be used as a payment method within UK payment chains.

“Actively Marketing”: Criteria

The HKMA will also consider multiple factors to determine whether a foreign person is "actively marketing" the issuance of FRS to the Hong Kong public. Some of the factors include:

• the language used in marketing messages, 
• whether the message targets a group of people residing in Hong Kong, and 
• whether a Hong Kong domain name is used for its website.

Similarly, under the EU MiCAR, to assess whether third-country firms solicit clients established or located in the Union, all facts and circumstances of the case are relevant. For instance, a website in an official language of the Union – and which is not customary in the sphere of international finance – should be a strong indication that a third-country firm is soliciting clients established or located in the Union. 

HKD-Referenced Stablecoins: Status

Since issuers of HKD-referenced stablecoins are likely to target members of the Hong Kong public, and because such issuance could have financial and monetary stability implications for Hong Kong, it is deemed necessary to include this activity within the MA’s regulatory scope, even if conducted outside of Hong Kong.

Similarly, under the EU MiCAR, an e-money token that references an official currency of a Member State shall be deemed to be offered to the public in the Union.

Authorized Institutions (AI): Leveraging Existing Authorization

Authorized institutions (AIs) are already subject to stringent prudential requirements and ongoing comprehensive supervision by the MA. Therefore it is proposed that certain licensing criteria should not apply to FRS issuers that are AIs. This is because these institutions are already governed by relevant regulatory requirements under banking regulations.

Requirements for FRS Issuers

International Standard Setters: Global Insights

Although stablecoins promise stability, they carry significant risks for their holders. A key concern for regulators is the potential inability to redeem stablecoins at their full value. Moreover, the reserve assets supporting stablecoins face credit, market, and liquidity risks, which could decrease their value. The degree of this impact relies on how well issuers manage these reserves. 

Inadequate reserve management could lead to a lack of liquid assets, preventing full and timely redemption for holders. This situation can make issuers prone to run risk, especially if holders doubt the issuer’s redemption capability. Additionally, joint research conducted by the IMF and FSB indicates that operational failures or poor governance can also disrupt a stablecoin's peg.

Regulators are also concerned about other risks linked to stablecoins, including dangers to consumers, market integrity, and financial stability, especially if connections to traditional finance expand. The broad adoption of stablecoins as payment tools, particularly by large tech firms with extensive customer bases, could weaken monetary policy, bypass capital flow controls, heighten fiscal risks, divert funds from the real economy, and jeopardize global financial stability. 

Most jurisdictions mandate that stablecoin issuers maintain reserves equivalent to the value of the stablecoins they issue. These reserves are generally required to be held in the form of cash, cash equivalents, or low-risk assets with minimal market, credit, and concentration risk. Additionally, many jurisdictions require these reserve assets to undergo independent audits and attestations, though the frequency of these attestations can vary. 

Regulatory frameworks often place significant emphasis on the protection of reserve assets. Issuers are typically required to hold these assets in segregated accounts. Furthermore, stablecoin issuers usually must meet minimum capital requirements and are obligated to publish a white paper or a similar document. They must also disclose the risks associated with the use of stablecoins.

FRS Issuers in Hong Kong: Key Requirements

• Full Backing by Reserve Assets. The amount of FRS issued must always be fully backed by reserve assets at any given point in time.
• High-Quality and High Liquidity Reserve Assets. Reserve assets must be of high quality and high liquidity, with minimal market, credit, and concentration risks. These include: (a) Coins and banknotes, (b) Deposits placed with licensed banks, (c) Marketable securities representing claims on or guaranteed by governments, central banks, or qualified international organizations with high credit quality, (d) Overnight reverse repurchase agreements with minimal counterparty risk backed by these securities (e) Tokenized versions of the above assets. 
• Currency Consistency. Reserve assets should be held in the same currency as that referenced by the FRS. Issuers need to obtain prior approval from the MA for any currency mismatch between the FRS's referenced currency and its reserve assets.
• Redemption Requests. FRS issuers must fulfill redemption requests within one business day under normal circumstances after the day a redemption request is received.
• Prohibition of Interest Payments. FRS issuers are prohibited from offering interest on stablecoins, although offering marketing incentives is permitted
• Segregation and Safekeeping of Reserve Assets. Reserve assets should be segregated and safeguarded, preferably with licensed banks in Hong Kong, though other jurisdictions may be reviewed on a case-by-case basis.
• Minimum Capital Requirements. FRS issuers must have a minimum paid-up share capital of HKD 25 million or 1% of the par value of FRS in circulation, whichever is higher.
• Comprehensive and Transparent Disclosure. There must be comprehensive and transparent disclosure of reserve assets, verified by an independent and trusted third party.
• White Paper Requirement. Issuers must provide a detailed whitepaper outlining the FRS.
• Restriction for Lending or Financial Intermediation Activities. FRS issuers should not engage in lending or financial intermediation activities, although this is not explicitly prohibited.
• Anti-Money Laundering and Counter-Terrorist Financing. Issuers must implement appropriate measures to mitigate and manage money laundering and terrorist financing risks.

Similarly, in the EU, fiat-pegged stablecoins must be fully backed by high-quality, highly liquid reserve assets with minimal risks. These reserves must be segregated and safeguarded. Issuers are also required to ensure redemption rights for customers and are prohibited from granting interest to mitigate the risk of stablecoins being used as a store of value. Additionally, there are minimum capital requirements, disclosure requirements, and white paper obligations that issuers must adhere to. Similar requirements are laid out in the UK proposal, although it remains to be seen how these will translate into final rules.

Conclusion

The FSTB and HKMA's proposed regulatory regime for FRS issuers represents a strategic move to fortify Hong Kong's financial infrastructure in the face of rapidly evolving digital asset technologies. By enforcing rigorous standards for fiat-referenced stablecoins, the authorities aim to protect the financial system from potential instability and ensure that stablecoins are issued and managed responsibly. 

This forward-looking approach not only aligns with global best practices but also reinforces Hong Kong's reputation as a leading financial center committed to innovation and security. The comprehensive oversight and clear regulatory guidelines will pave the way for a more stable and trustworthy digital asset ecosystem.