Stablecoins: Hong Kong proposes regulatory regime for issuance and offers

Focus on FRS: Hong Kong’s proposed stablecoin regulatory regime focusses on FRS, as opposed to other types of stablecoins such as those referencing gold or other assets. The stablecoin regulatory regime adopts a risk-based approach to regulating FRS issuers and seeks to apply the “same activity, same risk, same regulation” principle. Hong Kong authorities will be empowered to adjust the scope of application of the new regime as the virtual asset market evolves. Importantly, the scope of the regime versus the licensing available (including related licensing conditions) may mean that certain stablecoins are effectively banned or significantly restricted.

New legislation to be introduced in Hong Kong: To implement the proposed stablecoin regulatory regime, the Hong Kong government plans to introduce new legislation, instead of amending existing legislation such as the Payment Systems and Stored Value Facilities Ordinance (Cap. 584) and the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (“AMLO”). This was a specific feedback point in prior consultation rounds.  We consider that this approach may assist in enabling the evolution of the regime over time. 

Definition of FRS: Under the proposal, “FRS” is defined as a cryptographically secured digital representation of value that, among other features, purports to maintain a stable value with reference to one or more fiat currencies. However, financial products and instruments that are already covered by existing regulatory regimes, such as deposits, authorised collective investment schemes, authorised structured products, float stored in SVFs, SVF deposits and central bank digital currencies (“CBDCs”) will be excluded. This is critical, as avoiding overlap will be an important part of the lawmaking process and there can be a particularly fine line between stablecoins and other existing instruments such as SVFs, structured products, CIS and debentures. In this respect, we note that that many stablecoins are already regulated under existing Hong Kong laws. 

Licensing triggers: The following persons (each having a Hong Kong nexus) must obtain an FRS issuer licence from the HKMA (unless a specific exemption is available):

• any person that issues an FRS in Hong Kong;
• any person that issues an FRS referencing the Hong Kong dollar (“HKD-referenced stablecoin”); or
• any person that actively market its issuance of FRS to the public of Hong Kong.

Key licensing conditions and requirements for FRS issuers:

• The FRS issuer must be a Hong Kong-incorporated company with its senior management and key personnel based in Hong Kong. It must also meet minimum financial resources requirements. 
• The FRS issuer must have an effective stabilisation mechanism for its FRS by maintaining a pool of segregated, high-quality and highly liquid reserve assets (e.g., bank deposits in the referenced currency) in an amount at least equal to the total amount of FRS in circulation. In short, this means that fractionalisation by the issuer (by only maintaining sums expected to be redeemed at any given time) is not possible. The precise requirements at the bank custodial level are yet to be seen. The HKMA’s SVF regime generally requires a degree of negotiation and customisation regarding reserve arrangements and we expect a similar approach will be involved.
• FRS holders must be able to redeem their FRS on a timely basis, at par value and in the referenced currency, without having to pay disproportionate fees or meet unreasonable redemption conditions. 
• The FRS issuer must comply with a wide range of other licensing conditions and requirements relating to business activity restrictions, fitness and propriety, corporate governance, risk management, information disclosures, audit and AML/CFT compliance.  
• The HKMA has discretion to impose additional licensing conditions relating to matters such as reserve assets and restrictions on business activities. The HKMA will be empowered to impose, amend and cancel ongoing licensing conditions on the FRS issuer. The issuer must obtain consent from the HKMA before it issues any new FRS under its licence. 
• The HKMA will administer and enforce the new licensing and regulatory regime, and new criminal offences and an appeal mechanism will be introduced. Many of the HKMA’s powers over licensed FRS issuers will be similar to its powers under the Banking Ordinance (Cap. 155). 

Certain exemptions for AIs: Considering that AIs are already subject to prudential regulation and supervision by the HKMA, it is proposed that the licensing conditions and requirements relating to business activity restrictions, localisation and physical presence in Hong Kong and minimum financial resources will not apply to FRS issuers that are AIs. This arguably provides an advantage to AIs, but in our view and as explained in the consultation paper, these exemptions reflect the existing exceptionally high levels of AI regulation in Hong Kong, as well as other banking-related supervisory principles (including that certain matters are regulated by a global bank’s home country authorities).

Sandbox arrangement: The HKMA will introduce a sandbox arrangement for communicating supervisory expectations and guidance to companies that plan to issue FRS in Hong Kong. This is to be welcomed as we expect a significant level of interest in the coming months. Details regarding the sandbox arrangement will be announced separately.

FRS offering regime: Hong Kong’s proposed stablecoin regime will not only regulate the issuing of FRS, it will also regulate the offering of FRS. Under the proposed offering regime, only licensed virtual asset trading platforms (“VATPs”), HKMA-licensed FRS issuers, licensed corporations (“LCs”) regulated by the Hong Kong Securities and Futures Commission (“SFC”) and AIs (collectively, “regulated entities”) can offer FRS in Hong Kong or actively market such offering to the public of Hong Kong.  

The proposed FRS offering regime further distinguishes between two types of FRS: (1) FRS issued by HKMA-licensed FRS issuers, which can be offered to retail investors; and (2) FRS that are not issued by HKMA-licensed FRS issuers, which can only be offered to professional investors. Under the proposed FRS offering regime, it should still be possible for VATPs to offer FRS such as USDC and USDT to professional investors in Hong Kong on their platforms, even if the issuers of these FRS do not obtain an HKMA licence.

Transitional arrangement: The proposal includes a transitional arrangement that allows certain existing FRS issuers to migrate to the new regulatory regime in an orderly manner. In our experience working with virtual asset exchanges on their compliance with the new AMLO regime’s transitional arrangements, it is valuable to prepare for this early and to closely examine the eligibility requirements for transitional protection and applications, which can take time.

Custody requirements for FRS: The FSTB, HKMA and SFC are working separately on regulatory requirements relating to the custody of virtual assets such as FRS.  

Feedback due date: The HKMA and FSTB published a consultation paper which describes Hong Kong’s stablecoin proposal and seeks feedback from the public (“consultation paper”). Feedback on Hong Kong’s stablecoin proposal is due by 29 February 2024.  We strongly suggest considering a response if you are involved (or considering being involved) in issuing or offering stablecoins, or providing support services such as banking or custodial services to stablecoin issuers, intermediaries or platforms.

The remainder of this article provides further details regarding Hong Kong’s stablecoin proposal.

FURTHER DETAILS

1.   How does Hong Kong’s stablecoin proposal define key terms such as “stablecoin” and “FRS”?

Definition of “stablecoin”: Under the proposal, a “stablecoin” is defined as a cryptographically secured digital representation of value that, among other things:

• is expressed as a unit of account or a store of economic value;
• is used, or is intended to be used, as a medium of exchange accepted by the public, for the purpose of: (1) payment for goods or services; (2) discharge of a debt; and/or (3) investment;
• can be transferred, stored or traded electronically;
• uses distributed ledger or similar technology that is not controlled solely by the issuer; AND
• purports to maintain a stable value with reference to a specified asset, or a pool or basket of assets.

Treatment of algorithmic, derivative and other stablecoins: The proposed definition of stablecoin is broad enough to capture stablecoins that are not backed by actual reserve assets and instead derive their value from, or deploy stabilisation mechanisms involving, arbitrage or algorithms. However, these types of stablecoins will not satisfy the proposed licensing condition relating to reserve assets, which means that their issuers will not be able to obtain an FRS issuer licence from the HKMA.   

This is significant, as it means that a wide range of algorithmic, derivative and other stablecoins may effectively be banned from being issued or offered in Hong Kong.

The proposed treatment of algorithmic stablecoins is consistent with international standards. For example, the FSB July 2023 Stablecoin Recommendations state that algorithmic stablecoins do not have effective stabilisation mechanisms. For similar reasons, algorithmic stablecoins do not qualify as ‘Group 1b cryptoassets’ under the Basel cryptoasset standards. 

FRS definition: The FRS definition builds on the stablecoin definition. Specifically, FRS is defined as a “stablecoin” where the specified asset (i.e., reference asset) is one or more fiat currencies.  

Exclusions: The following financial products, instruments and arrangements that are already covered by existing regulatory regimes are excluded from the definition of stablecoin (and therefore also excluded from the definition of FRS): 

• deposits, including deposits in tokenised or digitally represented form;
• certain securities or futures contracts, primarily authorised collective investment schemes and authorised structured products;
• float stored in SVFs and SVF deposits;
• digital representations of fiat currencies issued by or on behalf of central banks (i.e., CBDCs); and
• certain digital representation of value that has a limited purpose (i.e., can only be used as a means of payment for goods or services provided by the issuer).

2.   Which entities will need to obtain an FRS issuer licence from the HKMA?

The triggers for the need to obtain an FRS issuer licence include: issuing an FRS in Hong Kong; issuing (regardless of location) any FRS that references the Hong Kong dollar; or actively marketing FRS issuance to the Hong Kong public.  

Specifically, under the proposed licensing regime for FRS issuers, no person shall:

• issue, or hold itself out as issuing, an FRS in Hong Kong;  
• issue, or hold itself out as issuing, a stablecoin that purports to maintain a stable value with reference to the value of the Hong Kong dollar; OR
• actively market its issuance of FRS to the public of Hong Kong, unless it is a company that holds an FRS issuer licence granted by the HKMA.  

Under the legislation to implement the proposed regime, engaging in these licensed activities without an FRS issuer licence will constitute a criminal offence. The inclusion of the second licensing trigger is particularly noteworthy, as it would not require the issuer to have any other nexus to Hong Kong, besides its FRS referencing the Hong Kong dollar.   

Meaning of “actively market”: The consultation paper provides that the term “actively market” may include:

• frequently calling on members of the Hong Kong public and marketing services;
• running a mass media program targeting the Hong Kong public; or
• internet activities that target the Hong Kong public.  

This is similar to the SFC’s interpretation of the term “actively market” under Section 115 of the Securities and Futures Ordinance (Cap. 571)[3] (“SFO”), which explains that marketing activities, whether taking place in or outside Hong Kong, would still constitute a licensing trigger if they target the Hong Kong public.  

3.   What key licensing conditions and requirements must an FRS issuer satisfy in order to obtain a licence from the HKMA?

The key licensing conditions and requirements for FRS issuers can be organised into the following categories. 

A.  Requirements relating to the reserve assets and stabilisation mechanism supporting the FRS

The FRS issuer must meet stringent requirements relating to the reserve assets backing its FRS and the associated stabilisation mechanism. These requirements are similar to the Basel Committee’s recently revised criteria for stablecoins to qualify as ‘Group 1b cryptoassets’ under the Basel cryptoasset standards. 

• High-quality reserve assets equal to the amount of FRS in circulation: The FRS issuer must ensure that the value of the reserve assets backing its FRS is at least equal to the par value of the FRS in circulation at all times. Any FRS with a stabilisation mechanism that is based on arbitrage or algorithms instead of actual reserve assets will not be acceptable. Reserve assets must be highly liquid and high-quality assets with minimal market, credit and concentration risk. Reserve assets should be held in the currency referenced by the FRS, although the HKMA may grant exceptions on a case-by-case basis. Importantly, AIs are not automatically exempt from this requirement, even though they benefit from certain other exemptions. This means that reserve assets cannot be treated as an AI’s own deposits (which do not need to be held 1:1). However, we expect a focus by AIs in consultation feedback on the potential differential treatment of “tokenised deposits” – that is, deposits recorded on blockchain or other types of digital ledger systems – which can overlap with stablecoins significantly.
• Segregation and safekeeping of reserve assets: The FRS issuer must have an effective trust arrangement to ensure that reserve assets are segregated from its other assets and are available to satisfy FRS holders’ redemption requests, including in the issuer’s  insolvency. Reserve assets should be held in segregated accounts at licensed banks, although the HKMA may approve other non-bank custodians if it is satisfied with the relevant custody arrangement. The FRS issuer must have effective internal control measures and procedures to protect reserve assets from operational risks such as the risk of theft, fraud and misappropriation. 
• Risk management and controls: The FRS issuer must have adequate policies and controls for the proper management of investment activities associated with the management of reserve assets to ensure that the FRS in circulation can be redeemed. The issuer is expected to conduct periodic stress testing to assess the adequacy and the liquidity of reserve assets.  
• Public disclosures, reporting and auditing: The FRS issuer must publicly disclose information such as the total amount of FRS in circulation, the mark-to-market value of reserve assets and the composition of reserve assets. In consultation with the HKMA, the issuer must engage a qualified and independent auditor to attest to a range of matters relating to the amount and composition of reserve assets. The total amount of FRS in circulation and the value of reserve assets must be disclosed at least daily, the composition of reserve assets must be disclosed at least weekly and attestation by the independent auditor must be performed at least monthly. 
• Prohibition on paying interest: FRS issuers must not pay interest to FRS holders. Instead, any income or loss from reserve assets (including interest payments, dividends and capital gains or losses) must be attributed to the FRS issuer. This distinguishes FRS (which function as a form of “private money”) from tokenised deposits, which can pay interest to depositors. 
• Ultimate responsibility: The FRS issuer is ultimately responsible for ensuring the effective functioning of its FRS’ stabilisation mechanism, even if it engages third parties to carry out stabilisation-related activities. This is an interesting proposal, as stablecoins often rely on market forces to achieve stable secondary market pricing (that is, the faith of the market that redemption against the issuer is available at par), and not necessarily the intervention of the issuer.

B.  Timely redemptions at par requirement

FRS holders must be conferred the right to redeem their FRS:

• on a timely basis;
• at par value;
• in the referenced currency;
• without being subject to unreasonable redemption conditions such as a very high minimum redemption amount; and
• without having to pay any previously undisclosed or disproportionate redemption fees.

Many of these requirements would require existing stablecoin issuers to make changes to their existing arrangements – for example, some issuers have terms that enable substituted redemption (i.e., redemption with some other asset). Some additional key questions for issuers to consider are:

• whether these requirements would in practice require them to enable redemption by “anyone who comes” (i.e., any holder), rather than only eligible holders. This would change the model of many stablecoins that generally circulate freely on secondary markets but on the understanding that not everyone can directly redeem; and
• linked with the above, whether they need to limit circulation to pre-approved holders to comply with redemption requirements and/or AML/CFT requirements.

We suggest considering these issues as part of the feedback on the proposal.

C.  Local incorporation and physical presence in Hong Kong requirements – these requirements do not apply to AIs

The FRS issuer must be a company incorporated in Hong Kong and must have a registered office in Hong Kong. Its chief executive, senior management team and key personnel must be based in Hong Kong and must exercise effective management and control over its FRS issuance and other related activities. Key personnel include the functional heads of operations, IT systems, financial management, control and risk management, compliance and internal audit.  

This may have a particular impact on significant global stablecoins. Existing issuers may wish to consider providing feedback on alternatives, such as local registered offices and adequate local personnel. This would be consistent with other areas of financial services regulation and we expect could also support the stability of the stablecoin arrangement and broader liquidity considerations, without impeding the need for appropriate regulatory oversight.

D.  Restrictions on business activities – these requirements do not apply to AIs

The FRS issuer must obtain the HKMA’s approval before it commences any new lines of business. Any new business lines must not introduce significant risks to the issuer.  

The FRS issuer may engage in activities that are ancillary or incidental to its issuance of FRS, such as providing wallet services to facilitate the issuance and redemption of its FRS. However, the FRS issuer should not engage in lending and financial intermediation activities and should not conduct other regulated financial activities such as those under the SFO, the Mandatory Provident Fund Schemes Ordinance (Cap. 485) or the Insurance Ordinance (Cap. 41).  

E.  Minimum financial resources requirements – these requirements do not apply to AIs

The FRS issuer must have adequate financial resources for operating its FRS issuance business. At a minimum, the issuer’s paid-up share capital should be the higher of:

• HKD25,000,000[4]; and 
• 2% of the par value of its FRS in circulation.  

The HKMA may impose a higher paid-up share capital requirement on the FRS issuer as a licensing condition. AIs are not subject to this, but have their own significant regulatory capital requirements. In this respect, we note that the HKMA has stated that it plans to implement the Basel cryptoasset standards in Hong Kong.

A consideration for issuers looking to provide feedback is whether alternatives to such high capital and financial resources requirements (while maintaining investor protection) are available. 

F.    Information disclosure requirements

Whitepaper: The FRS issuer must publish a whitepaper that discloses general information about itself, the rights and obligations of holders of its FRS, the stabilisation mechanism and reserve asset arrangements supporting the FRS, the underlying technology deployed by the FRS and relevant risk factors. The issuer must notify the HKMA prior to publishing the whitepaper. “Whitepaper” was a term more commonly used in the cryptoasset industry during the initial coin offering (“ICO”) boom era of 2016-2018 and whitepapers during that time widely varied in content, quality and enforceability. However, we interpret the “whitepaper” referenced here to include terms and conditions or another appropriate offering document. In our experience, we strongly recommend using appropriate legal documents that clearly set out the terms and conditions and are reviewed by counsel.

Redemption policies: The FRS issuer must also disclose its redemption policies, which should clearly describe the redemption process, the redemption timeframe and any applicable fees.  

G.    Governance, fit and proper, and knowledge and experience requirements

The controllers, chief executive and directors of the FRS issuer must be ‘fit and proper’ persons, and their appointment, as well as any changes in the ownership or management of the FRS issuer, all require the HKMA’s prior consent.  

The FRS issuer must be staffed by personnel with the necessary knowledge and experience to effectively discharge its responsibilities. 

H.    Risk management requirements

The FRS issuer must have risk management frameworks, processes and measures that include, among other features:

• controls to ensure the safety and integrity of data and systems;
• effective fraud monitoring and detection;
• technology risk management measures;
• robust contingency arrangements to address operational disruptions; and
• other operational and security safeguards that are commensurate with the FRS issuer’s business.

The FRS issuer must perform risk assessments on a frequent basis (at least annually) to ensure the adequacy and effectiveness of its internal controls, risk management and governance processes.

I.    Audit requirements

The FRS issuer must submit annual audited financial statements to the HKMA. When required by the HKMA, the FRS issuer must also submit reports prepared by external independent auditors and assessors on matters such as the management of reserve assets, cybersecurity and the integrity of smart contracts. We look forward to seeing further details about these requirements in due course and how they compare to the existing SVF and virtual asset exchange external assessment requirements with respect to which we have been assisting clients.

J.    AML/CFT requirements

The FRS issuer must have adequate and appropriate systems and controls for preventing and combating possible money laundering and terrorist financing.  

Its AML/CFT systems, controls, policies and procedures must comply with the AMLO, as well as all applicable standards, rules and guidelines published by the HKMA and the Financial Action Task Force (“FATF”), including the “travel rule”. The "travel rule” requires relevant institutions to obtain and disclose details regarding the sender and recipient of a virtual asset transfer to their counterpart institutions, akin to wire transfer requirements.

In our experience, key considerations for stablecoin issuers include:

• how broadly they allow their stablecoins to circulate (permissioned versus open);
• who can redeem;
• whether they monitor transactions, and how/when; and
• whether their selected technology permits intervention, such as remote burning or freezing, and whether (and in what circumstances) they wish to use such powers.

4.   Who can offer FRS and to which types of investors? 

Hong Kong’s proposed stablecoin regime will not only regulate the issuing of FRS, it will also regulate the offering of FRS. 

Only regulated entities can offer FRS in Hong Kong: Under the proposed FRS offering regime, only regulated entities (defined above) can offer FRS in Hong Kong or actively market such offering to the public of Hong Kong. An HKMA-licensed FRS issuer can only offer its own FRS.  When offering FRS, an LC must hold a licence for Type 1 regulated activity (dealing in securities) and must be permitted by the SFC to carry out dealing in virtual assets. The consultation paper provides that “offer” refers to the act, as a principal or an agent, of providing a channel for a person to acquire the FRS, which includes (without limitation) distribution, providing trading or brokerage services for acquiring the FRS.  

Only FRS issued by HKMA-licensed issuers can be offered to retail investors: The proposed FRS offering regime further distinguishes between two types of FRS: (1) FRS issued by HKMA-licensed FRS issuers; and (2) FRS that are not issued by HKMA-licensed FRS issuers. In a speech announcing the consultation paper, the Chief Executive of the HKMA clarified that “only stablecoins issued by licensed issuers could be offered to retail investors.”[5] According to the consultation paper, FRS that are not issued by HKMA-licensed FRS issuers are not suitable for use by the general public. Therefore, these FRS can only be offered to professional investors. Regulated entities making such offers must clearly indicate that the FRS are not issued by an HKMA-licensed FRS issuer.

Comparing the proposed FRS issuing and offering regimes: The following table explains the scope of application and key requirements of the FRS issuing regime and the FRS offering regime under Hong Kong’s stablecoin proposal. 

5.   What are the proposed transitional arrangements for existing FRS issuers?  

According to the consultation paper, the new licensing and regulatory regime for FRS issuers will commence one month upon gazettal of the new legislation implementing the regime (“commencement date”).  

To facilitate smooth transition of existing FRS issuers into the new regime, existing FRS issuers that are conducting FRS issuance activities with “meaningful and substantial presence in Hong Kong” prior to the commencement date (“qualifying existing issuers”) may continue to operate during a non-contravention period of six months, provided that they have submitted an FRS issuer licence application to the HKMA within three months following the commencement date.  

In assessing whether an FRS issuer has meaningful and substantial operations in Hong Kong, the HKMA will consider factors such as whether the entity operating the FRS issuance is incorporated in Hong Kong, whether it has a physical office in Hong Kong with staff exercising central management and control over the FRS issuance and whether the FRS it issues has been circulated to FRS holders that are not its own affiliates.  

Qualifying existing issuers that fail to submit a licence application to the HKMA within the abovementioned timeframe will need to close down its FRS issuance business in an orderly manner by the end of the fourth month following the commencement date.  

6.   Where can I learn more about stablecoins and related issues?  Come speak to us

We have advised issuers and platforms on stablecoins over many years, including bank-issued stablecoins, algorithmic stablecoins, trust-based stablecoins and many other similar instruments and arrangements.

KWM’s bilingual financial regulatory, financial markets, structured products and international funds teams have extensive experience in advising financial institutions, fund houses and fintech companies on a broad range of matters related to stablecoins, tokenisation, digital assets, emerging fintech and financial regulation. 

We are familiar with the unique and nuanced commercial and legal issues faced by financial institutions, asset managers and fintech companies in the fast-evolving regulatory landscape in Hong Kong, China Mainland, Australia, Europe and the United States. We can provide a range of support for your stablecoin and digital assets-related projects, including initial structuring strategy, advice on licensing and product authorisation requirements as well as the preparation and negotiation of product offering and transaction documents.  

Come speak to us - we would be pleased to share our further insights with you. 

This alert is provided for general information purposes only and does not constitute legal advice.

*In this article, “Hong Kong” or “HK” means the “Hong Kong Special Administrative Region of the People’s Republic of China”, and “PRC” or “China Mainland” means the People’s Republic of China, excluding Hong Kong, Macao Special Administrative Region and Taiwan.