Hong Kong Monetary Authority Releases Findings on Crypto-Asset and Stablecoin Discussion Paper

The Hong Kong Monetary Authority (HKMA) released the findings of a discussion paper on crypto-assets and stablecoins on Tuesday, putting forward a comprehensive set of proposals for regulating stablecoins. The regulator targets 2023/24 as the implementation date for its new regulatory regime.

About a year ago, the HKMA published a discussion paper on crypto-assets and stablecoins and invited feedback from stakeholders. The regulator said it received feedback from 58 respondents on this.

During this one year, the cryptocurrency market evolved, but the stablecoin market, in particular, experienced heightened price volatility, said HKMA while noting the collapse of TerraUSD in May 2022 and the implosion of FTX six months later in the same year.

Against this backdrop, authorities have called for more comprehensive regulation of stablecoins to address the financial stability risks they could pose, said HKMA. It noted how the international regulatory bodies, standard-setting bodies, and some major jurisdictions have already responded with more specific policy recommendations and regulatory measures along with proposals for stablecoins.

Now, in its latest discussion paper, the regulator outlines its own thoughts regarding prioritizing the development of a regulatory framework for “payment-related stablecoins.” Here, HKMA refers to those stablecoins that may have the potential to develop into a widely acceptable means of payment. At the same time, HKMA aims to provide flexibility in the regime to adjust the scope of stablecoins that may be subject to regulation as needed.

Higher Risk to Monetary & Financial Stability

In its Jan. 2023 discussion paper, HKMA points out that while stablecoins technically include those crypto-assets that aim to maintain a stable value, international regulatory bodies and major jurisdictions have given higher priority to those stablecoins that have the potential to be used across multiple jurisdictions for payments and/or as stores of value.

Stablecoins that claim to be backed by fiat currencies are given more attention by regulators because they are more likely to be used in payments and have linkages with the traditional financial system. This, HKMA said in its paper, could create higher risks to monetary and financial stability than any other type of not only stablecoins but also crypto-assets.

However, it added that major jurisdictions recognize the need for flexibility in the regulatory regime to keep up with the rapidly changing market and international regulatory developments.

With that, the regulator expects its draft legislation to set out key issues such as:

(i) Defining the structures and activities that would be regulated or not regulated under the legislation, the key regulatory requirements, and the range of effective and proportionate powers that should be granted to the HKMA to implement the regulatory regime;

(ii) The range of powers that should be given to the authority to allow for the timely update of the regulatory regime to scope in additional structures or activities;

(iii) The relevant guiding factors the authority should regard in exercising its powers.

The HKMA said its legislative approach involves weighing the pros and cons of introducing new legislation and amending existing laws to implement the regulatory regime.

Additionally, the HKMA agrees that in regard to the possible cross-border use cases of stablecoins, there should be efficient and effective cooperation and coordination among relevant financial regulators. It added that the HKMA would also continue participating in the relevant international discussions and contribute to incorporating a suitable cooperation and coordination arrangement in the future regulatory regime.

Key Activities

Based on the feedback received, the HKMA will implement a regulatory regime. Under its new regulations, the key activities relating to stablecoins will be subject to a mandatory licensing regime.

The HKMA said it would use a risk-based approach in scoping stablecoin structures for regulation under the proposed regime. The key activities that are related to an in-scope stablecoin and will be regulated by the government include:

• Governance: establishment and maintenance of the rules governing a stablecoin arrangement;
• Issuance: issuing, creating, or destroying a stablecoin;
• Stabilization: stabilization and reserve management arrangements of a stablecoin, notwithstanding such arrangements, are provided by the issuer or not;
• Wallets: provision of services that allow the storage of the users’ cryptographic keys, which enable access to their stablecoin holdings and the management of such stablecoins.

As a priority, the HKMA will start with regulating stablecoins that claim to be backed by one or more fiat currencies. This is because these types of stablecoins pose higher and more immediate risks to economic stability, it said. The authority will also have the built-in ability to cover other types of stablecoins for regulation under its proposed regime in the future.

Licensing Requirements

Under the regulatory regime, entities will be required to obtain a license from the Hong Kong Monetary Authority.

These entities will include those conducting a regulated activity in Hong Kong; actively marketing a regulated activity to the public of Hong Kong; conducting a regulated activity involving a stablecoin that claims to be backed by the Hong Kong dollar (HKD); or an entity that the authority believes should be so regulated due to being a matter of significant public interest.

With this new regulatory regime, HKMA aims to provide a comprehensive regulatory framework under which appropriate regulatory requirements will be developed on areas, including but not limited to ownership, governance and management, financial resources requirements, anti-money laundering (AML) and counter-terrorist financing (CFT), risk management, regular audits and disclosure requirements, and user protection.

It will further cover stablecoins’ full backing and redemption at par with HKMA stating: “stablecoin holders should be able to redeem the stablecoins into the referenced fiat currency at par within a reasonable period.”

With this, the regulator means the value of the reserve assets of a stablecoin arrangement must meet the value of the outstanding stablecoins at all times. It said the reserve assets should also be of high quality and liquidity.

However, the same doesn’t apply to algorithmic stablecoins, which derive their value based on arbitrage or algorithm, as HKMA said those stablecoins would not be accepted.

The regulator also mentions principal business restrictions under which the regulated entities shouldn’t be conducting any activities that deviate from their principal business as permitted under their relevant licenses. HKMA illustrated that wallet operators should not engage in lending activities.

In regard to the issue of providing arrangements much like the deposit protection scheme, the HKMA will continue to monitor relevant international developments. Based on that, the regulator will consider if the same protection outcome may already be delivered through other means, such as reserve assets equaling the amount of outstanding stablecoins in circulation.

Next Steps

According to the HKMA, once its proposed approach gets a broad agreement, they intend to develop an agile, risk-based regulatory regime for stablecoins with requirements to be applied proportionately. As per the paper, this will minimize risks of regulatory arbitrage, protect users, and help ensure monetary and financial stability.

The HKMA will take into account all the responses it receives, monitor market developments, engage with the industry, and draw reference from the relevant international discussions when working on the details of the regulatory regime, it said.

A more detailed consultation, with more granular information about the regulatory regime, will be conducted in due course, with further assessments to be made, particularly regarding whether to introduce new legislation or amend existing laws, how to minimize possible regulatory overlaps, the local incorporation requirement and addressing risks that may be posed by the provision of bundled or several financial services by affiliated entities, said HKMA.

Overall, HKMA’s paper signals the government’s clear intention to embrace digital ledger technology and develop a new stablecoin regime while maintaining the financial regulatory system. It is also a signal of further collaboration between regulators, other interested parties, and stakeholders in the context of financial services, with HKMA signaling its role as a coordinator for different financial regulators.

Pushing to Become an Asian Blockchain Hub

The findings from the report signals that Hong Kong is making a push to become an Asian blockchain hub, with the HKMA emphasizing the responsible development of blockchain technology, crypto-assets, and stablecoins. It also highlighted the importance for government regulators to be involved in creating an appropriate regulatory framework to ensure this responsible development.

Hong Kong’s commitment to becoming a global cryptocurrency hub remains despite the challenges posed by markets and rivals. For those that do not know, Sam Bankman-Fried’s now-defunct crypto exchange FTX and its sister company Alameda Research have roots in the city.

“As certain crypto exchanges collapsed one after another, Hong Kong became a quality standing point for digital asset corporates,” said Hong Kong Financial Secretary Paul Chan Mo-po earlier this year. He added that Hong Kong has a robust regulatory framework for the cryptocurrency industry that “matches international norms and standards.”

At the same event, Joseph Chan, the undersecretary for financial services and the Treasury for the government of Hong Kong, also revealed that the city is preparing to issue more licenses for digital asset trading firms.

Since China banned crypto transactions on the Chinese mainland in September 2021, Hong Kong has been attempting to establish the city as a regional crypto industry hub by releasing a series of policy documents about blockchain and crypto the next year.

Late last year, Hong Kong officially unveiled its new approach to crypto during its Fintech Week when it highlighted Web3 integration. Shortly after that, officials permitted the listing its first crypto-based ETFs, which have since raised over $80 million.

This followed Hong Kong’s SFC announcing that retail investors would be able to trade “highly liquid” digital assets. This development and a mandatory exchange licensing regime are expected to come into force in June 2023, with applicants allowed a nine-month grace period.

All these developments clearly show that Hong Kong continues to push ahead with the development of the Web 3.0 industry as it aims to become a regional hub for the nascent industry.