On January 12, 2022, the Hong Kong Monetary Authority (HKMA) released a discussion paper on crypto-assets and stablecoins. The paper discusses the adequacy of the existing regulatory framework in light of the challenges arising from the growing use of stablecoins and other types of crypto-assets in financial markets.
The stablecoins market has experienced exponential growth in use and distribution. The HKMA pointed out that the market capitalization of all stablecoins hit $150 billion in December, accounting for 5% of the entire crypto market. Accompanying such growth is increasing regulatory scrutiny of stablecoins and their issuers. In the discussion paper, the HKMA lays out the scope of its new regulatory regime, which covers payment-related stablecoins.
The HKMA places a special focus on payment-related stablecoins believing that they may have a higher potential for being incorporated into the mainstream financial system across the globe. The HKMA noted due to its pegging characteristics, users and/or market players may differentiate stablecoins from other types of crypto-assets, with the perception that some stablecoins may be more readily developing into a commonly accepted means to store value and/or make payments. Since these stablecoins have a higher chance of being adopted as widely acceptable means of payment, the HKMA observed that they may raise broader and monetary implications.
Regulatory concerns surrounding stablecoins
The discussion paper addresses some key risk considerations that regulators have in relation to stablecoins including:
Financial Stability Risks: These risks include payment integrity and banking stability risks. The regulators are worried that if the stablecoins become a widely accepted means of payment, then any stablecoins-related operational disruption or failure will negatively impact economic activity, normal functioning, and public confidence in the financial system. Further, if financial institutions including banks were to increase their exposure to stablecoins, and/or play multiple roles in the stablecoins ecosystem, then the integrity of the stablecoin ecosystem will directly affect financial institutions’ financial health, business model, and stable operation.
Monetary Stability Risks: Currency substitution and monetary policy transmission mechanism both fall under monetary stability risks. Regulators are concerned about fiat-backed stablecoins substituting domestic fiat currencies, particularly, in those jurisdictions where the value of the domestic currency is unstable and payment infrastructures are not well developed. Additionally, It is possible that some stablecoin issuers may choose Hong Kong dollars (HKD) as a backing currency. The issuance and redemption of HKD backed stablecoins, if sizable, may affect interbank HKD demand and supply.
Settlement Risk: Settlement finality generally means the discharge of an obligation by a transfer of funds and securities that have become irrevocable and unconditional. Enforcing this settlement is difficult in the stablecoins ecosystem, as forks — changes in the protocol or technical upgrades made to the protocol network— can reverse a technical settlement and create misalignment with legal finality. The HKMA urged issuers of payment stablecoins to have measures in place to address the potential losses that stem from such misalignment.
User Protection: The HKMA acknowledged that the users might suffer losses from operation disruptions or failures of a stablecoin arrangement with no or limited recourse unless the recourse mechanism is legally and clearly stipulated. Further, the HKMA also acknowledged that given the complexity and novelty of different stablecoins, many users might do not fully understand the risks associated with them. Therefore, the HKMA stated that users should be provided with sufficient information and disclosures about the nature, rights, and risks associated with stablecoins.
Illicit Financing Risks: Stablecoins also pose illicit finance concerns and risks to financial integrity, including concerns related to compliance with rules governing AML/CFT activities
To effectively handle associated risks, the HKMA laid out eight major policy directions:
Firstly, the HKMA stated that it intends to take a risk-based approach focusing initially only on payment-related stablecoins. The HKMA will particularly focus on regulating asset-linked stablecoins, for example, fiat or commodity pegged stablecoins rather than algorithmic stablecoins.
Secondly, the HKMA may either expand the Payments Systems and Stored Value Facilities Ordinance (PSSVFO) or introduce a new law to cover a broad range of stablecoin-related activities. For example, issuing or destroying stablecoins, managing reserve assets, executing transactions, and facilitating redemption of stablecoins.
Thirdly, theHKMA stated that it intends to regulate stablecoin-related activities with a risk-based approach rather than in a one-size-fits-all manner. It plans on implementing authorization, prudential, liquidity, systems control, governance, risk management, AML/CFT, and reporting requirements amongst others. Stablecoin issuers will also be required to maintain and manage reserves backing stablecoins.
Fourthly, no person or entity will be allowed to carry out activities related to stablecoins in Hong Kong or actively market to the public of Hong Kong unless such an entity is incorporated in Hong Kong and holds a relevant license under HKMA. Therefore, foreign entities looking to conduct business under the intended stablecoins regulatory regime will need to incorporate a company under Hong Kong law. The Hong Kong incorporated company will then have to apply for a license to the HKMA and hold that license if and when granted.
Fifthly, the HKMA has stated that it will collaborate and coordinate with other financial regulators when defining the scope of its oversight and will seek to avoid regulatory arbitrage, including in relation to areas which ‘may be subject to regulation by more than one local financial authority. The consultation is open until the end of March, and the HKMA is expected to formulate a plan by July this year for the new regime to be in place by 2023 or 2024.
Sixthly, while not expressly stating that it will not require stablecoin issuers to be regulated as authorized institutions (AIs) under the Banking Ordinance, the HKMA has indicated that it expects that the requirements applicable to stablecoin issuers will instead borrow from Hong Kong’s current regulatory framework for stored value facilities (SVF). However, the HKMA has signalled that certain stablecoin issuers may be subject to higher prudential requirements than SVF issuers where they issue stablecoins of systemic importance
Seventhly, the HKMA will provide authorized institutions (AIs) with more detailed regulatory guidance in relation to the provision of crypto-related intermediary services by AI to the customers. The HKMA will continue to monitor the development of crypto-assets closely and maintain a close dialogue with various stakeholders to strengthen the regulation of crypto as needed in light of relevant international regulatory developments and to avoid any regulatory arbitrage in these activities.
Lastly, the HKMA encourages the current or prospective players in the stablecoins ecosystem to respond to this paper and submit relevant views to us, so that we could take the feedback into account when formulating the regulatory framework.
How Can Merkle Science Help?
To enable access to potential benefits of stablecoins while mitigating the risks they pose to users, investors, and the financial system, the regulatory oversight over stablecoins is increasing. In order to protect themselves from exposure to the AML/CFT risks, VASPs should proactively put compliance frameworks in place to monitor all transactions surrounding stablecoins and to mitigate AML/CFT risks.
Merkle Science provides a predictive crypto risk and intelligence platform, setting the standard for the next generation of financial safeguards and criminal detection. We are creating the infrastructure necessary so that a full range of individuals, entities, and services may transact safely with crypto. Merkle Science’s highly customizable platform and proprietary Behavioral Rule Engine is easy-to-use, allowing institutions to detect illicit activity beyond the blacklists and detect suspicious activity that could have previously been undetected.