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Hong Kong Seeks Public Input on Proposed Approach to Stablecoin Regulation

Hong Kong Seeks Public Input on Proposed Approach to Stablecoin Regulation

February 23, 2024

Introduction

The Hong Kong Monetary Authority (“HKMA”) and the Financial Services and the Treasury Bureau (“FSTB”) issued a joint public consultation paper (“the Consultation Paper”) on December 27, 2023, to enact new legislation to implement a licensing regime for fiat-referenced stablecoin (“FRS”) issuers by adopting a risk-based and agile approach in implementing the regulatory regime.

This Consultation Paper intends to clarify regulatory advice for stablecoin issuers and offer suitable protection measures for stablecoin users as part of the Hong Kong Government's plan to promote sustainable and responsible development of virtual assets (“VAs”).

The TerraUSD collapse in May 2022 demonstrates that stablecoins, particularly FRS, may have broad and frequent interaction with the mainstream financial system and day-to-day commercial, financial, and economic activities, posing more direct and imminent hazards to the financial system.

HKMA and FSTB’s Proposed Definitions of Stablecoins and Fiat-Referenced Stablecoin (FRS)

Although the Consultation Paper’s primary goal is to regulate FRS, it also proposes incorporating a definition in the new legislation based on currently used definitions by international organizations, standard-setting bodies, and other popular terminology in the VA market.

Stablecoins

The Consultation Paper proposed defining stablecoins as a cryptographically secured digital representation of value that (1) is expressed as a unit of account or a store of economic value; (2) 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; (3) can be transferred, stored, or traded electronically; (4) uses a distributed ledger or similar technology that is not controlled solely by the issuer; and (5) purports to maintain a stable value with reference to a specified asset, or a pool or basket of assets.

However, the proposed definition specifically excludes any deposits in tokenized or digitally represented forms, securities, float held in stored value facilities (SVFs) and central bank-issued digital fiat currencies. The HKMA and FSTB consider these excluded assets to be subject to different regulatory regimes.

FRS

FRS is categorized as stablecoin with a specified asset of one or more fiat currencies. Issuance of an FRS would be a regulated stablecoin activity under the proposed legislation, primarily because FRS could potentially evolve into a widely accepted means of payment, posing more immediate monetary and financial stability risks than other VAs or other types of stablecoins, such as commodity-referenced stablecoins.

Criteria for Obtaining an HKMA License Under the FRS Licensing Regime

Unless permission is granted by HKMA, it is held that no person shall (1) issue, or represent themselves as issuing, an FRS in Hong Kong; (2) issue, or represent themselves as issuing, a stablecoin that purports to maintain a stable value in relation to the value of the Hong Kong dollar; or (3) actively market its issuance of FRS to the Hong Kong public, unless it is a company that holds an FRS issuer license granted by the HKMA.

The recommended requirements and conditions for obtaining a HKMA license are summarized below:

Criteria and Conditions

1. Management of Reserves and Stabilization Mechanism:

Full backing: The value of the reserve assets supporting an FRS is always at least equal to the par value of the FRS in circulation;
Investment limitations: reserve assets must be of high quality and liquidity with minimal market, credit and concentration risks;
Segregation and safekeeping of reserve assets through an appropriate trust structure, as well as ensuring internal control measures are in place to protect against operational risks;
Risk management and controls – the FRS issuer must establish comprehensive policies and controls to manage reserve assets and ensure sufficient funds to redeem FRS. To deal with large-scale redemptions or liquidity stress scenarios, they must also implement effective liquidity risk management methods, including stress testing;
Disclosure and reporting – The FRS issuer must routinely publish to the public the total FRS in circulation, mark-to-market value, and reserve asset composition. Furthermore, an independent auditor must undertake monthly attestation;
FRS issuers shall not pay interest to FRS users;
Effective stabilization – FRS issuers must be accountable for ensuring that the stabilization mechanism of the FRS they issue is effective.

2. Redemption Requirements:

FRS users must be able to redeem their FRS at par value without incurring additional expenses and in a timely manner; The FRS issuers must also ensure direct redemption to users if the exchange from FRS to fiat currencies becomes unavailable. If the FRS issuers are unable to meet these requests, a contingency plan for orderly redemption must be implemented.

3. Restrictions on business activities:

FRS issuers must obtain approval from the HKMA before introducing new business lines;
FRS issuers can provide incidental services, such as wallet services, but cannot engage in lending, financial intermediation, and regulated activities or any other activities defined under the Securities and Futures Ordinance (“SFO”) (Cap. 571), the Mandatory Provident Fund Schemes Ordinance (Cap. 485) or the Insurance Ordinance (Cap. 41).

4. Physical Presence in Hong Kong:

The company must be incorporated in Hong Kong and have a registered office in the territory; as well as key staff based and exercising control there.

5. Financial Resources Requirements:

FRS issuers should have a minimum paid-up share capital of HKD 25 million or a specified percentage of the part value of the FRS in circulation, whichever is higher;
The HKMA reserves the ability to impose a higher value than that listed above.

6. Disclosure Requirements:

As part of its informational disclosure, FRS issuers must publish a white paper outlining the details, FRS users’ rights and obligations, redemption policies, and other user-protection mechanisms.

7. Governance, Knowledge and Experience:

An FRS issuer’s controllers, CEOs, and directors must be fit and proper. Any appointment of these individuals, or any change in management of the FRS issuer, must be approved by the HKMA;
The FRS issuer must have a robust corporate governance structure staffed with personnel who, in the view of the HKMA, have the necessary knowledge and expertise to carry out the operations.

8. Risk Management Requirements

The FRS issuer must have appropriate risk management processes and measures for its operations, including but not limited to: adequate security and internal controls to ensure the safety and integrity of data and systems; effective fraud monitoring and detection measures; technology risk management measures; robust contingency arrangements to address operational disruptions; and other operational and security safeguards that are commensurate with the scale and complexity of the business.

9. Audit Requirements:

FRS issuers must provide the HKMA with annual and audited financial statements, as well as financial-related reports prepared by external auditors and assessors, upon request.

10. Anti-Money Laundering and Counter-Financing of Terrorism Requirements:

The FRS issuers must implement appropriate measures to address money laundering and terrorist financing risks;
These measures must comply with the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (“AMLO”) (Cap.615) and other relevant HKMA rules;
It is important to highlight that the measures would only comprise acceptable customer due diligence processes for FRS issuance and redemption, transaction monitoring, and wire transfer requirements in accordance with the standards set by the Financial Action Task Force and AMLO standards.

11. Other Licensing Matters

Eligibility – all entities would be entitled to apply for a license if they could satisfy the same set of licensing and regulatory standards;
Ongoing licensing conditions – The HKMA would be able to impose, amend and cancel ongoing licensing conditions on an FRS issuer;
Issuing more than one FRS: The FRS issuer will be required to obtain consent from the MA before issuing any new FRS under its license;
The FRS issuer will be granted an open-ended license;
FRS issuers (including licensees that are approved institutions) must have their license number shown on any advertising materials and consumer-facing interfaces of any software applications, and HKMA has the authority to impose license fees on them on an annual basis.

Custody and Offering of FRS

If the criteria above are met, the Consultation Paper believes that any applicants may be qualified for a HKMA license. In essence, it is determined that (1) HKMA-licensed issuers, (2) SFC-licensed corporations having a Type 1 license (dealing in securities) and with permission to deal with virtual assets, and (3) SFC-licensed virtual asset trading platforms (“VATP”) would be permitted to offer FRS to the general public.

Note that non-HKMA-licensed issuers can only offer FRS to professional investors.

Civil and Supervisory Sanctions

It is proposed that HKMA can impose a range of civil and supervisory sanctions based on the severity, circumstances, or length of a violation under the proposed regulatory regime. Sanctions can include (1) issuing a caution, warning, reprimand, order to take specified action(s), and supervisory sanctions including temporary suspension, suspension or revocation of license, or a combination of such; (2) a pecuniary penalty not exceeding HKD 10 million or three times the amount of profit gained or loss avoided as a result of the contravention, whichever is greater; or (3) any combination of (1) and (2).

Proposed Implementation Arrangements

The deadline for written submissions on the Consultation Paper is February 29, 2024.

If approved, the proposed regime will go into force one month after the new legislation is published in the gazette. Nevertheless, the HKMA proposes a 6-month transitional period for current FRS issuers to comply the new criteria, provided they apply to the HKMA within the first three months after the new legislation takes effect.

Conclusion

It is encouraging that the HKMA decided to hold a second consultation on the topic after receiving responses on the Discussion Paper on Crypto-assets and Stablecoins in January 2022 and the conclusions in January 2023. The Consultation Paper acknowledges the FRS’s distinctive characteristics and welcomes the proposal for separate legislation to prevent subjecting an FRS issuer to multiple regulatory regimes. We are confident that thorough discussion by market stakeholders, regulators and lawmakers will help Hong Kong develop a regulatory framework for stablecoin issuance and will continue to monitor and advise on future developments.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William K. Pao, an O'Melveny partner licensed to practice law in California, Edwin Kwok, an O’Melveny partner licensed to practice law in Hong Kong, AnnaLou Tirol, an O’Melveny partner licensed to practice law in California, and Wenting Yu, an O’Melveny partner licensed to practice law in New York and California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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