Hong Kong Tokenization Buzz 2024: Hong Kong Proposes Regulatory Regime for Fiat-Referenced Stablecoin Issuers

Hong Kong is taking the global lead in developing the legal and regulatory infrastructure to support and drive the next wave of financial innovation. Following the introduction by the Securities and Futures Commission (Commission) of (a) a comprehensive licensing regime¹ for intermediaries interested in engaging in the trading of virtual assets² (VA) and (b) enhancing guidance to market participants engaged in VA-related activities³, market participants are looking forward with great anticipation to when and how laws and regulations will further evolve in support of Hong Kong’s development into a Web3 hub⁴.

A major milestone in spearheading this growth spurt is the introduction of guidance in the form of Circulars⁵ to intermediaries to encourage the adoption of technology in product offerings by way of tokenization. As alluded to earlier⁶, the Hong Kong government’s support in encouraging tokenization extends to permitting such product offerings to be made available to retail investors.

Another impetus to pushing Hong Kong ahead of the curve as the indisputable fintech leading jurisdiction is the development of an innovative financial market infrastructure (FMI) to facilitate seamless interbank settlement of tokenized money⁷. Let’s consider what has recently been publicly announced by the Hong Kong Monetary Authority (HKMA), Hong Kong’s banking regulator, as its initiatives in rendering support to the development of the tokenization market.

HKMA shows support on stablecoin regulations and other payment initiatives

On January 31, 2023, the HKMA⁸ published its consultation conclusions to the discussion paper⁹ that forms the basis for a regulatory framework for stablecoins: What are stablecoins, and why are they the first to be regulated¹⁰?

On December 28, 2023, the HKMA and the Financial Services and Treasury Bureau (FSTB) jointly published a public consultation paper¹¹ to gather views on the legislative proposal to regulate fiat-referenced stablecoin (FRS) issuers. The consultation period ended on February 29, 2024.

Hot off the press! The HKMA and FSTB jointly published the consultation conclusions on July 17, 2024¹². We set out the salient features of the new licensing regime below for your ease of reference.

The Consultation Conclusions indicate that a bill to implement the regulatory proposals set out will be introduced later in the year and the HKMA intends to implement a six-month noncontravention period for interested FRS issuers to submit their licence applications to the HKMA.

Salient features of the new licensing regime for “fiat-referenced” stablecoin (FRS) issuers

^ “Decentralised distributed ledger” refers to a distributed ledger in which no person has the unilateral authority to control or materially alter its functionality or operation.

# Factors considered by the HKMA regarding the cover of ”reserve assets” include the need for the FRS issuer to manage liquidity and market risks, its operational needs and the classification of high-quality liquid assets~ in banking regulations, as well as other applicable international standards.

~ “High quality and high liquidity” reserve assets generally include (a) coins and banknotes, (b) deposits placed with licensed banks, (c) marketable securities representing claims on or guaranteed by governments, central banks or qualified international organizations with high credit quality, (d) overnight reverse repurchase agreements with minimal counterparty risk backed by these securities, and (e) tokenized versions of the above assets.

Ø Interest payment is generally considered as the distribution of any profit, income, or other returns that are proportionate to the length of period during which a user holds the FRS, and/or the size of FRS held by an FRS user.

∞ White paper should include, among others, general information about the FRS issuer, disclosures regarding risks associated with suing the FRS, the technology used, the mechanism and procedures for issuance, distribution and redemption, rights of potential FRS users, and applicable conditions and fees for redemption.

α “Offer”, in relation to an FRS, means communication to the public in any form, or by any means, presenting sufficient information on the term of the offer and channels through which the FRS is to be offered so as to enable a person to decide whether to acquire the FRS.

HKMA’s key concerns and FRS issuers’ action points

Although the Consultation Conclusions indicate that HKMA will adopt a risk-based regulatory approach when assessing the FRS issuers’ management of reserve assets during the license application process, the HKMA expects FRS issuers to demonstrate how their investment policies for reserve assets and liquidity management policies are commensurate with the size and complexity of the FRS issuers’ businesses and could meet redemption requests in normal and stressful scenarios.

Further, in support of its license application, prospective FRS issuers are expected to present viable and proper use cases to demonstrate sustainability of its operations and also its business plans.

Notably, the HKMA expects FRS issuers to

• discuss investment policies with the HKMA; investment instruments other than those listed to be of “high quality and high liquidity” will be considered on a case-by-case basis
• obtain prior approval from the HKMA for currency mismatch between the FRS’ referenced currency and reserved assets with limited flexibility afforded to FRS issuers of HKD-referenced stablecoins to include USD-denominated reserve assets
• submit draft of relevant trust deed together with an independent legal opinion in relation to the use of trust arrangements to segregate reserve assets from FRS issuers’ own assets to HKMA for review
• seek HKMA’s prior approval of any foreseeable difficulty in fulfilling redemption requests within one business day (e.g., unforeseen market stress scenarios)
• seek HKMA’s prior consent before issuing a new FRS

Please stayed tuned for our upcoming publication on the HKMA’s supervisory powers exercisable over the proposed FRS licensing regime.

Looking forward/forward looking – the bright new world

Noting the HKMA’s momentum toward building an innovative FMI to support the development of Hong Kong’s tokenization market, payment service providers interested in becoming a part of Hong Kong’s fintech ecosystem should consider taking the next steps below.

(1) Prepare for licensing as a FRS issuer

The Consultation Conclusions modified various aspects of the proposed regulatory proposal, and the legislative timetable is yet final since the proposed bill has yet to be submitted to the Legislative Council for vetting. Further, as it is yet to be determined as to how the proposed legislative regulations on FRS issuers will fit into Hong Kong’s existing licensing and regulatory regimes, in particular, the SFC’s licensing regime for VA service providers, payment industry intermediaries may consider acquiring a licensed corporation or securing a license with the Commission as only specified licensed entities (i.e., licensed corporations and licensed VA trading platforms) are permitted to offer FRS to the public of Hong Kong.

(2) Be a fiat payment and wallet provider¹³

In Hong Kong, different players in the payments industry are subject to different regulations¹⁴. Essentially, there are three types of payment service providers currently participating in the VA payment industry:

• “Money services operators” that provide “money services” (i.e., a money changing service and/or remittance service) will be expected to obtain a licence with the CCE under the Anti-Money Laundering and Counter Terrorist Financing Ordinance (AMLO) unless exempted from the licensing requirements: For example, authorized institutions, licensed corporations authorized insurers, SVF issuers (as defined below), system operators, or settlement institutions of a designed retail payment system under the Payment Systems and Stored Value Facilities Ordinance (PSSVFO).
• “Stored value facility issuers” are those that issue a facility to be used for (a) storing the value of an amount of money that is paid into the facility and (b) making payments for goods or services under an undertaking given by the issuer or for making payments to another person under an undertaking given by the issuer. Apart from licensed banks that are deemed licensed to operate an SVF, these issuers must be licensed with the HKMA.
• “Clearing and settlement systems” or “retail payment systems” that facilitate credit and debit card transactions and interbank account transfers are subject to designation and oversight of the HKMA if the system operates in Hong Kong and either (a) for clearing and settlement systems accepts for clearing or settlement transfer orders denominated in Hong Kong dollars or (b) for retail payment systems accepts for transfer, clearing, or settlement transfer orders denominated in any currency or declared medium of exchange.

The Consultation Conclusions indicated that the HKMA does not currently intend to include other activities associated with stablecoins (e.g. management and custody of reserve assets), as well as other non-stablecoin-specific activities (e.g. storage of private keys and provision of wallet services) to be covered by the proposed licensing regime.

Payment services providers wishing to participate in the evolving payment services market in Hong Kong may consider exploring the necessity to obtain a licence under existing regulatory regimes in Hong Kong, for example, under the SFO, the AMLO and/or PSSVFO if they are interested in providing payment services in relation to VAs or “tokenized” assets.

(3) Space to watch on the stablecoin front

Still in flux, the HKMA and FSTB expect to deal with the following issues:

¹ Please refer to Sidley’s five-part series on Hong Kong Virtual Asset Trading Platform Operators Licensing Regime:
*Part 1 (Dual Licensing Regime and Key Personnel Requirements), published May 31, 2023: https://www.sidley.com/en/insights/newsupdates/2023/5/hk-vatp-licensing-regime-1-dual-licensing-regime-and-key-personnel-requirements
*Part 2 (Key Infrastructure Requirements Under the VATP Guidelines), published May 31, 2023: https://www.sidley.com/en/insights/newsupdates/2023/5/hk-vatp-licensing-regime-2-key-infrastructure-requirements-under-the-vatp-guidelines
*Part 3 (Standalone AML Chapter), published June 1, 2023: https://www.sidley.com/en/insights/newsupdates/2023/06/hk-vatp-licensing-regime-4-standalone-aml-chapter
*Part 4 (Final VATP Requirements and Key Onboarding Requirements), published June 1, 2023: https://www.sidley.com/en/insights/newsupdates/2023/06/hk-vatp-licensing-regime-3-final-vatp-requirements-and-key-onboarding-requirements
*Part 5 (Closing Remarks), published June 2, 2023: https://www.sidley.com/en/insights/newsupdates/2023/06/hk-vatp-licensing-regime-5-closing-remarks
² This is a space to watch as the government, in view of increased threat of fraud, launched a public consultation on legislative proposals to introduce a licensing regime for providers of over-the-counter (OTC) trading services of VA (VA OTC operators). Similar to the introduction of the licensing regime for VA trading platform operators, VA OTC operators, irrespective of whether the services are provided through physical outlets or otherwise, will be required to become licensed with the Commissioner of Customs and Excise (CCE). The CCE will be empowered to supervise AML and CTF conduct of the licensees and will be responsible for enforcing the statutory and regulatory requirements under the licensing regime. The consultation period closed on April 12, 2024. Please access the consultation paper here: https://www.fstb.gov.hk/fsb/en/publication/consult/doc/VAOTC_consultation_paper_en.pdf.
³ Please refer to the following Sidley publication for the conduct requirements applicable to intermediaries conducting VA-related activities in Hong Kong:
*Hong Kong Fintech Regulatory Update: From “A Leap of Faith” to “A Vote of Confidence”: Part I Expanding Clientele (Retail Access), published on November 16, 2023: https://www.sidley.com/en/insights/newsupdates/2023/11/hong-kong-fintech-regulatory-update-from-a-leap-of-faith-to-a-vote-of-confidence
⁴ During the visit of Christopher Hui, Secretary for Financial Services and the Treasury, to the Netherlands on June 3, 2024, he stated that the legislative proposal to regulate issuers of stablecoin is an important measure facilitating Web3 ecosystem development in Hong Kong. Please refer to the Hong Kong government’s press release of June 5, 2024: https://www.info.gov.hk/gia/general/202406/05/P2024060500148.htm.
⁵ Please refer to the Sidley publication Hong Kong Fintech Regulatory Update: From “A Leap of Faith” to “A Vote of Confidence”: Part II Exploring Technology (Tokenisation), published on November 22, 2023: https://www.sidley.com/en/insights/newsupdates/2023/11/hong-kong-fintech-regulatory-update-part-2-tokenisation.
⁶ See footnote 3, second bullet point.
⁷ HKMA’s press release on March 7, 2024 (2024 Press Release) – HKMA unveils Project Ensemble to support the development of the Hong Kong tokenization market: https://www.hkma.gov.hk/eng/news-and-media/press-releases/2024/03/20240307-5/.
⁸ Please refer to Sidley’s publication “Prepare for a New Era: Hong Kong Monetary Authority Issues Conclusions on Cryptoassets and Stablecoin Regulation,” published on February 7, 2023, for details: https://www.sidley.com/en/insights/newsupdates/2023/02/hkma-issues-conclusions-on-cryptoassets-and-stablecoins-regulation.
⁹ Discussion Paper on Crypto-assets and Stablecoins, published by the HKMA in January 2022 (Discussion Paper): https://www.hkma.gov.hk/media/eng/doc/key-information/press-release/2022/20220112e3a1.pdf.
¹⁰ Quoting from Page 3 of the Discussion Paper, “Crypto-asset refers to a type of private digital asset that depends primarily on cryptography and distributed ledger or similar technology” and “Stablecoin is generally considered as a sub-set of crypto-asset.” To summarize from the Discussion Paper, “due to its ‘pegging’ characteristics … users and/or market players differentiate stablecoins from other crypto-assets as stablecoins give the perception/expectation that they may be more readily developing into a commonly acceptable means to store value and/or make payments, thus having a higher potential for being incorporated into the mainstream financial system across the globe.”
¹¹ Legislative Proposal to Implement the Regulatory Regime for Stablecoin Issuers in Hong Kong, published by the FSTB and HKMA in December 2023 (Consultation Paper): https://www.hkma.gov.hk/media/eng/doc/key-information/press-release/2023/20231227e4a1.pdf.
¹² Consultation conclusions to the Consultation Paper (see above footnote 11), published by the FTSB and HKMA on July 17, 2024 (Consultation Conclusions): https://www.hkma.gov.hk/media/eng/doc/key-information/press-release/2024/20240717e3a1.pdf
¹³ Page 24 of Report 1 of Project Genesis. Project Genesis is BIS Innovation Hub (BIS) and HKMA’s first green finance project that explores the possibility of combining blockchain, smart contracts, internet-of-things, and digital assets in green bond offerings. Report 1 was issued in November 2021: https://www.bis.org/publ/othp43_report1.pdf.
¹⁴ Chapter 10, Hong Kong Payment Services, Payment Services: Law and Practice (Elgar, 2022).