Introduction
Given the rapid development of virtual assets (“VAs”) and Stablecoins, and the use of VAs as a medium of exchange, Hong Kong had issued several discussion and consultation papers on the approach to regulate VAs.
On 27 December 2023, the Financial Services and the Treasury Bureau and the Hong Kong Monetary Authority (“HKMA”) issued a public consultation paper on the legislative proposal regarding the regulatory regime for Stablecoin issuers in Hong Kong, and the consultation conclusions was recently issued on 17 July 2024 (“Consultation Conclusions”).
Separately, on 12 March 2024, the HKMA also announced the launch of the Sandbox Arrangement for Stablecoin Issuers (“Sandbox”), with the aim to communicate Hong Kong’s supervisory expectations to the Sandbox participants and obtain feedback from them on the proposed regulatory regime, so as to facilitate its subsequent implementation.
In light of these recent developments, this article aims to provide an overview of the proposed regulatory regime on Stablecoins in Hong Kong and its implications.
What are Virtual Assets and Stablecoins?
Before going into the proposed regulatory framework, it will be a good idea to first briefly understand what VAs and Stablecoins are.
According to the HKMA, VAs are “digital representations of value that are cryptographically secured, typically through the use of distributed ledger technology, like blockchain”. They can be digitally traded, transferred or used for payment, and could therefore make payments easier, faster and cheaper than traditional methods. The most common examples of VAs include cryptocurrencies such as Bitcoin and Ethereum, and non-fungible tokens (NFTs).
Nonetheless, since most VAs are not backed by physical assets, this makes them extremely speculative and volatile. This is where Stablecoins come in.
Stablecoins are a form of VAs that seek to maintain a stable value with reference to certain assets, in order to address the issue of price volatility. They are typically pegged to fiat currencies (i.e. being fiat-referenced Stablecoin, “FRS”), and Stablecoin users can redeem their coins against fiat currencies upon request. As FRS is the only type of Stablecoin covered by the present proposed regime, we will focus on FRS in the remainder of this article.
Current Regulatory Framework
As of today, there is no specific regulatory framework for FRS. However, it is considered that two of the ordinances are relevant.
Firstly, a dual-licensing regime for virtual asset trading platforms (“VATPs”) and virtual asset service providers (“VASPs”) was introduced by the Hong Kong Securities and Futures Commission (“SFC”), following an amendment of the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (“AMLO”) in 2022. Accordingly, VATPs and VASPs are required to be licensed and regulated by the SFC.
Secondly, FRS may be covered under the Payment Systems and Stored Value Facilities Ordinance (Cap. 584) as certain FRS arrangements may to some extent be similar to stored value facilities (“SVFs”), which are regulated thereunder.
Despite having the said ordinances, it is generally agreed that a new piece of legislation should be dedicated to the regulation of FRS, as it has distinct features that justify a standalone regulatory regime from the securities and SVF regime. This could also serve as a foundation for extension of the local regulatory regime for other VA-related activities in the future.
Proposed Regulatory Framework
Under the proposed regulatory framework, all FRS issuers and persons who advertise the issuance of FRS must be licensed by the HKMA.
Having completed a two-month public consultation period, the Consultation Conclusions recently released show that the proposed regulatory regime has received overall support from the industry and relevant stakeholders. Save that further clarification and detailed guidance will be needed upon implementation, most agreed with the proposed scope of the licensing regime. Taking into account the Consultation Conclusions, below is a summary of the regime:
1. Management of reserves and stabilization mechanism
Specifically, the proposal suggests the following conditions:
(a) The value of the reserve assets backing the FRS should at least be equal to the par value of the FRS in circulation at all times.
(b) The reserve assets must be of high quality and high liquidity with minimal market, credit and concentration risk, such as coins, banknotes and deposits placed with licensed banks. While reserve assets should be held in the same currency as that referenced by the FRS, HKMA’s prior approval may be obtained for any currency mismatch.
(c) The FRS issuer must segregate the reserve assets from their other assets and put in place an effective trust arrangement to ensure that they are available for FRS holder’s redemption.
(d) The FRS issuer must have adequate risk management and controls regarding the reserve assets.
(e) The total amount of FRS in circulation and the value and composition of the reserve assets must be regularly disclosed to the public. The FRS issuer should also engage a qualified and independent auditor to perform at least monthly attestation on the adequacy of the reserve assets.
(f) The FRS issuer must not pay interests received from the reserve assets to FRS users save for offering marketing incentives.
(g) The FRS issuer must be responsible for the effective stabilization of the FRS it issues.
2. Redemption requirements
FRS users should have a right to redeem their FRS at par value against the reserve assets, and the redemption process must be timely, within one day in normal circumstances, and without undue costs or unreasonable conditions.
3. Restrictions on business activities
The FRS issuer must seek the HKMA’s approval before it commences any new lines of business, and must demonstrate that it has adequate resources such that the new business would not introduce significant risks to its performance as an FRS issuer.
4. Physical presence in Hong Kong
The FRS issuer must 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 to allow the HKMA to exercise supervision on such entities.
5. Financial resources requirement
The FRS issuer must have adequate financial resources, including a minimum paid-up share capital, which is proposed to be either HKD 25,000,000 or 1% of the par value of the FRS in circulation, whichever is higher.
6. Disclosure requirements
The FRS issuer must disclose general information about, among other things, itself, its stabilization mechanism and reserves management arrangements, and clearly define the redemption policy and process.
7. Governance, knowledge and experience
The senior management of an FRS issuer must possess a sufficient level of knowledge and experience and prior consent must be sought from the HKMA for any appointment or changes of its controllers, chief executives and/or directors.
8. Risk management requirements
The FRS issuer must have proper risk management processes and measures for its operation and perform at least annual risk assessments to ensure the adequacy and effectiveness of its internal controls, risk management and governance processes.
9. Audit requirements
The FRS issuer must submit audited financial statements to the HKMA on an annual basis.
10. Anti-Money Laundering and Counter-Financing of Terrorism requirements
The FRS issuer must have adequate and appropriate systems of control for preventing or combating possible money laundering and terrorist financing, and ensure it complies with the AMLO.
Further, it is added that the use cases and business plans of prospective FRS issuers will be taken into account in reviewing their license applications, and FRS issuers will be required to have effective complaints handling and redress mechanisms in place.
Aside from the above licensing conditions, it is proposed that the authorities be empowered to modify the regulatory regime to address risks arising from emerging types of Stablecoins, activities or entities, and for the HKMA to supervise and investigate the FRS issuers in case of breach or failure of the FRS. Criminal and civil sanctions will also be imposed for breaches of the regulatory regime and the HKMA will be given enforcement powers in relation to the sanctions.
Implications
While some may view that the proposal is imposing seemingly onerous obligations upon FRS issuers, a well-regulated environment is necessary to minimize the potential risks FRS poses in the course of developing the Stablecoin ecosystem in Hong Kong.
It is anticipated that the proposed regulatory regime will help provide greater protection to Stablecoin users and ultimately safeguard Hong Kong’s financial stability while continuing to foster innovation.
This article is published in the November 2024 issue of Hong Kong Lawyer.
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