Hong Kong Monetary Authority provides update on proposed regulatory framework for payment-related stablecoins and upcoming crypto-asset guidance

The Hong Kong Monetary Authority (HKMA) has recently issued its Discussion Paper on Crypto-assets and Stablecoins, setting out the regulatory landscape globally and in other jurisdictions, as well as the current landscape in Hong Kong, and how it believes the Hong Kong regulatory framework should be expanded to cover payment-related stablecoins.

Members of the public and the industry are invited to submit their feedback by 31 March 2022.

This follows a number of regulatory reforms in recent years relating to crypto-assets (also referred to as virtual assets), namely the Securities and Futures Commission (SFC)’s regulatory framework for virtual asset portfolio managers and virtual asset fund distributors introduced in November 2018 (see our bulletins of November 2018 and October 2019), the SFC’s regulatory framework for the licensing of centralised virtual asset trading platforms (on an opt-in basis) introduced in November 2019 (see our bulletin), and the Hong Kong government’s consultation conclusions on proposals to enhance the Anti-money Laundering and Counter-terrorist Financing Ordinance (AMLO) by introducing a licensing regime for virtual asset service providers, targeted for tabling before the Legislative Council this year (see our bulletin).

The HKMA considers that certain key functions in a typical stablecoin arrangement may not be captured by the proposed enhancements to the AMLO, given that those enhancements were not primarily targeted at stablecoins. The HKMA is therefore considering expanding the scope of the Payment Systems and Stored Value Facilities Ordinance (PSSVFO) or introducing new legislation to facilitate the implementation of the intended regulatory regime focusing on activities relating to payment-related stablecoins.

The HKMA intends to introduce the new regime no later than 2023/2024.

Key points to note and other HKMA initiatives

• It is proposed that the new regime adopts a risk-based and proportionate approach, and will focus on payment-related stablecoins (in particular asset-linked stablecoins) at the initial stage, with flexibility to accommodate other types of crypto-assets in the future if needed.
• An HKMA licence will be required to engage in specified stablecoin-related activities, and the licensee must be a Hong Kong-incorporated entity.
• The HKMA’s initial thoughts regarding the new regime is set out in the next section of this bulletin. The HKMA encourages interested parties (in particular current or prospective players in the stablecoins ecosystem) to provide feedback. It will take into account the feedback and consider the next steps, including assessing the need to issue further documents on specific aspects of the regulatory regime in 2022/2023, with the aim of introducing the new regime no later than 2023/2024.
• The HKMA has indicated that it is also addressing the implications of crypto-assets from two other dimensions:
  • Investor protection – The HKMA and the SFC are working together to set out their supervisory expectations on the investor protection aspects of authorised institutions (AIs)’ provision of crypto-asset related intermediary services to customers.
  • AIs’ interface with crypto-assets – The HKMA will “soon” issue a circular to provide guidance on issues arising from AIs’ growing business interface with crypto-assets, such as user protection, credit risk, market risk, operational risk, financial crime risk (including fraud and money laundering / terrorist financing risk), and prudential treatment of any direct exposures of AIs to such assets.

HKMA’s initial views on a regulatory framework for payment-related stablecoins

What overall regulatory approach does HKMA intend to take?

The HKMA proposes to:

• adopt a risk-based and proportionate approach, giving priority to areas which pose higher risks while allowing room for innovation; and
• maintain a degree of flexibility in the regime to accommodate evolving market development and international discussions.

What types of stablecoins should be regulated? (Questions 1 and 7 of the discussion paper)

The HKMA intends to focus on payment-related stablecoins at this stage, in particular asset-linked stablecoins (such as those linked to a single fiat currency, as opposed to algorithm-based stablecoins).

The HKMA notes that existing stablecoins are mostly asset-linked and predominantly pegged to the USD, and appear to be more prevalent in the market and more likely to be perceived as having the potential to develop into a widely used means of payment, as compared to algorithm-based stablecoins.

Nonetheless, flexibility will be built into the regulatory regime to enable it to be readily extended to other types of stablecoins as needed in the future.

The HKMA is also continually monitoring the risks which may be posed by crypto-assets more broadly, including unbacked crypto-assets, and in doing so will maintain a close dialogue with other financial regulators and stakeholders, as well as international standard setters, on the need to strengthen the regulation over such assets.

What types of stablecoin-related activities should be regulated? (Question 2 of the discussion paper)

The HKMA has proposed that the following stablecoin-related activities should be regulated. This is not intended to be an exhaustive list and may be expanded in the future:

• issuing, creating or destroying stablecoins;
• managing reserve assets to ensure stabilisation of the stablecoin value;
• validating transactions and records;
• storing the private keys providing access to stablecoins;
• facilitating the redemption of stablecoins;
• transmission of funds; and
• executing transactions in stablecoins.

Will there be regulatory overlap with other financial regulatory regimes? (Questions 5 and 6 of the discussion paper)

The HKMA is aware that there are other regulatory regimes including those administered by it under the PSSVFO, and by the SFC (under the current opt-in licensing regime and the upcoming AMLO regime).

In developing the regulatory regime for stablecoins, the HKMA will work closely with other financial regulators and stakeholders to identify possible areas for further collaboration and coordination, and to avoid regulatory arbitrage. These areas would cover possible cases which may be subject to regulation by more than one local financial authority.

The HKMA expects that the rules and requirements under the proposed regime would take relevant aspects of Hong Kong’s current approach to stored value facility and payment regulation (under the PSSVFO) at a minimum to avoid regulatory arbitrage. Depending on the systemic implication of the stablecoin arrangements, under a risk-based approach, they should be required to be subject to higher prudential requirements (such as capital and liquidity requirements) to ensure protection of users.

Who should be eligible licensees? (Question 4 of the discussion paper)

An HKMA licence is proposed to be required in order to engage in the following:

• carrying out the stablecoin-related activities mentioned above in Hong Kong; and
• actively marketing such activities to the public of Hong Kong as a business.

In order to enable the HKMA to exercise effective regulation on the relevant entities, a licensee must be a Hong Kong-incorporated entity. A foreign company/group which intends to engage in the above will therefore need to incorporate a company under Hong Kong law, and such company will be the entity applying to the HKMA for a licence.

What authorisation and regulatory requirements should be included in the regulatory regime? (Question 3 of the discussion paper)

The HKMA proposes to apply the following requirements to the stablecoin-related activities using a risk-based approach rather than in a one-size-fits-all manner:

• Authorisation requirements – The HKMA will further develop these authorisation requirements in law and such requirements are expected to be complied with by the relevant licensed institution on an ongoing basis after authorisation;
• Prudential requirements – Requirements relating to adequacy and effective management of capital and liquidity;
• Fit and proper requirements – Requirements relating to the fitness and propriety of the controllers (including shareholder controllers and indirect controllers) and senior management of stablecoin arrangements;
• Maintenance and management of reserves of backing assets – Requirements to support and stabilise the value of the outstanding stock of stablecoins, and requirements relating to the clarity and enforceability of the legal claims, titles, interests and other rights of stablecoin holders;
• Systems, controls, governance and risk management requirements – Requirements relating to a sound risk-management framework with respect to the legal, credit, liquidity, operational, anti-money laundering and counter-terrorist financing (AML/CFT) and other risks of the stablecoin arrangement. The stablecoin arrangement’s ownership structure and operation should allow for clear and direct lines of responsibility and accountability;
• AML/CFT requirements;
• Redemption requirements – Requirements relating to the clarity, robustness, and timeliness of redemption;
• Financial reporting and disclosure – Requirements relating to the firms’ disclosures to regulator(s) and users, and relating to the rights that firms should provide towards users;
• Safety, efficiency and security requirements – Requirements for safeguarding against cyber-security, operational and business continuity risks etc; and
• Settlement finality – A stablecoin arrangement should provide clear and final settlement regardless of the operational settlement method used.