Hong Kong Tokenization Buzz 2024: Tokenized Real World Assets X Tokenized Deposits = “Atomic” Settlement — a Reality?

August 29, 2024

摘要

Pending the introduction of the draft bill implementing the legislative proposal to implement a regulatory regime for fiat-referenced stablecoin issuers in Hong Kong, this article summarizes Hong Kong Monetary Authority (HKMA) initiatives in support of tokenized payments (wCBDC, e-HKD, or tokenized deposits) used for settlement in tokenized asset transactions. This timely article published after the HKMA and Securities and Futures Commission jointly announced the launch of the Project Ensemble Sandbox seeks to provide an overview of published guidance, a timetable of developments to date and actionable steps for interested financial intermediaries to participate in shaping Hong Kong’s Web 3 hub.

Pending publication of the draft bill introducing a new legislation to implement a licensing regime for fiat-referenced stablecoin (FRS) issuers in Hong Kong, the regulatory proposal should be assessed against various fintech policy initiatives embarked by the Hong Kong Monetary Authority (HKMA) supportive of the introduction of new means of payment during the tokenization process.

Putting the Two Together Through Project Ensemble

On March 7, 2024, the HKMA unveiled Project Ensemble to support development of the Hong Kong tokenization market¹. As summarized in the 2024 Press Release, Project Ensemble is a new wholesale central bank digital currency (wCBDC) project that seeks to explore innovative financial market infrastructure (FMI) that will facilitate seamless interbank settlement of tokenized money through wCBDC.

With wCBDC as the foundation, tokenized deposits, which are digital representation of commercial bank deposits, issued by commercial banks that will be made available to the general public, will first be used for tokenized asset transactions. Through the proposed launch of wCBDC Sandbox to further research and test tokenization use cases, for example, settlement of real-world assets (e.g., green bonds, carbon credits, aircraft, electric vehicle charging stations, electronic bills of lading, and treasury management), it is expected that experimentation and exploration outcomes in the wCBDC Sandbox could establish a new FMI that bridges the gap between tokenized real-world assets and money in transactions.

Project Ensemble is a key component of the HKMA’s initiatives in facilitating the development of the tokenization market, comprising e-HKD. An overview of other aspects and impact of Project Ensemble is set out in the Appendix.

Foreseeably, the issuance of a regulated Hong Kong stablecoin or e-HKD could provide a powerful alternative to investors when making on-chain payment. With the progressive stance taken by the HKMA on exploring and experimenting with the possible adoption of “tokenized” money in tokenized offerings through Project Ensemble, the HKMA’s updates on Project Ensemble bear watching. If implemented, the outcome of the HKMA’s policy initiatives under Project Ensemble is expected to have groundbreaking impact on financial markets.

Tokenization Update

Before achieving “atomic” settlement, the HKMA has been experimenting with the tokenization process through Project Genesis². Project Genesis demonstrates how novel online payment methods³ can/should be integral to the tokenization process to achieve greater investor inclusion, efficiency, privacy, and system integration in a product offering:

There are flexible payment options through on-ledger stablecoin fiat – this will bypass off-ledger payment routes to provide investors with greater access to investment opportunities.
Settlement occurs immediately and atomically against payment – this will reduce the need for or eliminate upfront collateral that will reduce overall operational burden, eliminate counterparty risk, and increase efficiency.
Recordkeeping and reconciliation of holding records are automated – this will facilitate controlled and risk-free processing of scheduled coupon and redemption payments, thus rendering protection to contractual parties.
An integrated program tracks performance of underlying investments – this will provide greater transparency on the use of proceeds.

Starting with small steps and as outlined above, the tokenization process can be integrated into different aspects spanning from payment, settlement, recordkeeping, or performance reporting taking advantage of blockchain technology.

Tokenization of Green Bonds

For settlement purpose, at the inaugural tokenized green bond offering in February 2023, the Hong Kong government being the first jurisdiction to tokenize green bonds for offering to professional investors. The primary issuance was made through settlement on a delivery-versus-payment basis between securities tokens (representing beneficial interests in the bond) and cash tokens (representing a claim for HKD fiat against the HKMA) on a T+1 basis across a private blockchain network. A year later, the Hong Kong government’s second digital bond issuance process has adopted a digital native format in which issuance will not be through traditional central securities depositories and subsequently converting the bond into digital format.

Tokenized Product Issuance

Short of tokenization of bonds, the Securities and Futures Commission (SFC) — securities regulator of Hong Kong — has also been taking the lead in providing guidance to financial market participants in the adoption of tokenization as a new means of securities offering. To date, the SFC has authorized its first publicly offered product — HSBC’s Gold Token. It is expected that market participants are actively exploring how to adopt tokenization in new product offerings.

Actionable Next Steps

Actionable first steps taken by industry participants in exploring product offerings targeted at the retail market include launching publicly authorized exchange-traded funds that are exposed to virtual assets (VA). These innovative investment products not only invest directly into bitcoin (spot or futures) and/or ether or thematically invest into the web3-related universe, for example, artificial intelligence or digital payments, but also use new investment vehicles, such as the Hong Kong–domiciled Open-Ended Fund company. These pioneering investment products are commendable and demonstrate Hong Kong’s diversity as an issuer’s paradise for product offerings⁴. Needless to say, given the SFC’s push for Hong Kong to become an international green finance hub, Hong Kong will continue to create trailblazing products that meet sustainability needs enhanced by the adoption of technology.

Ahead of either issuing FRS or launching new tokenized (green) products, market participants may opt to participate in the VA space through distributing VA-related products, for example. This approach aligns with the SFC’s expectations of how market participants will likely gain exposure to VA since the SFC updated requirements of the Joint Circular⁵ applicable to intermediaries seeking to distribute investment products with exposure to VA (including tokenized products) shortly after its introduction of guidance on tokenization and doing so only after less than three months since it last updated the Joint Circular.

Set out below is an updated summary of the SFC’s conduct requirements applicable to distributors of VA-related products⁶.

Distribution of VA-related products
1.	Regulators	SFC and HKMA
2.	Legislation/Guidance	Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615, Laws of Hong Kong) (AMLO) Securities and Futures Ordinance (Cap. 571, Laws of Hong Kong) (SFO) Joint Circular⁷
3.	In-Scope Intermediaries	Type 1 (Dealing in Securities)/ Type 9 (Asset Management)/ AMLO licensee
4.	Product Types for Professional Investors Only⁸	SFC Conduct Requirements Existing Conduct Requirements apply
4.1	Likely Complex Products⁹	Universally applicable to nonqualified corporate professional investors¹⁰ and individual professional investors¹¹ clear and easily comprehensible information on the underlying VA investments warning statements relating to the VA-related product risk disclosure statements (can be one-off) specific to VA
4.1.1	VA-related products¹², for example, overseas nonderivative VA exchange-traded products (ETP), unless these fall into the “Product Types for Retail Investors.”	suitability¹³ requirements irrespective of whether solicitation or recommendation exists full scope of complex product requirements¹⁴ VA knowledge test¹⁵ is applicable to nonqualified corporate professional investors¹⁶ and individual professional investors¹⁷: If a client does not possess VA knowledge, the distributor may proceed only if adequate training has been provided to the client on the nature and risks of VA; and clients have sufficient net worth to be able to assume the risks and bear potential losses of trading VA-related products. (Additional Investor Protection Measures)
4.1.2	Other exchange-traded VA-related derivative products (whether or not traded on a specified exchange) if they are unlike the complex exchange-traded derivative on the nonexhaustive list of examples of noncomplex and complex products published on the SFC website.	full scope of complex product requirements Additional Investor Protection Measures apply
4.1.3	Non-SFC-authorized VA funds/tokenized products	Existing Conduct Requirements apply and Appendix 4¹⁸ of the Joint Circular Selling Restrictions Requirements For Hong Kong Prospectus regime under the Companies (Winding up and Miscellaneous Provisions) Ordinance Compliance with Part IV of the SFO For Overseas – Local marketing rules apply
5.	Product Types for retail investors	SFC Conduct Requirements Universally applicable to retail investors clear and easily comprehensible information on the underlying VA investments warning statements relating to the VA-related product risk disclosure statements (can be one-off) specific to VA
5.1	VA-related derivative products traded on regulated exchanges specified by the SFC (Regulated Specified Exchanges¹⁹)	existing guidance on complex exchange-traded derivative products apply but may execute clients’ orders on exchange without the need to comply with suitability requirement or minimum information and warning statements requirement where there is no solicitation or recommendation made Additional Investor Protection Measures apply
5.2	Exchange-traded VA derivative funds authorized/approved for retail offering by regulator in designated jurisdiction (Authorized/Approved by Designated Regulator²⁰)
5.3	Public VA futures ETF and VA spot ETFs (i) authorized by the SFC and traded on the Stock Exchange of Hong Kong Limited (SEHK) or (ii) authorized/approved in a designated jurisdiction for offering to retail investors by the respective regulator and traded on a specified exchange
6.	Other VA funds authorized by the SFC for public offering
6.1	Listed and traded on SEHK with no solicitation or recommendation	may execute clients’ orders on exchange without the need to comply with suitability requirement or minimum information and warning statements requirement Additional Investor Protection Measures apply
6.2	Not listed, or listed but traded off exchange	suitability requirements clear and easily comprehensible information on the underlying VA investments warning statements relating to the VA-related product risk disclosure statements (can be one-off) specific to VA
6.3	VA derivative funds	In addition to the above conduct requirements, compliance with paragraphs 5.1A and 5.3 of the Code of Conduct expected client assessment on nature and risks of VA-related derivative products conducted risk disclosure statements²¹ (can be one-off) specific to VA futures contracts provided
7.	Tokenized SFC-authorized investment products²²	Underlying products should meet applicable requirements in the relevant rules, regulations, and product codes²³ Compliance with Tokenized Securities Circular
8.	Terms & Conditions	No, but various SFC guidance apply
9.	Financial Accommodation	Only if assured that the client has the financial capacity to meet obligations arising from leveraged or margin trading in VA-related products
10.	Advance Notification Obligation to the Regulators	Change of business activities (including changes of type of clientele served)

The table above summarizes essentially the SFC’s guidance applicable to nonauthorized institutions (i.e. banks) when conducting sales and distribution of SFC-tokenized products. Circling back to the HKMA — Hong Kong’s banking regulator — the HKMA has, likewise, issued specific guidance to authorized institutions (AIs) on the sale and distribution of tokenized products²⁴ that fall outside the regulatory remit of the SFO. For example, these may include tokenized non-SFO-regulated currency-linked and/or interest rate–linked deposits or investment products, tokenized spot precious metal, and tokenized bank deposits.

Prior to engaging in tokenized product-related activities, AIs should engage in prior discussions with the HKMA and also take heed of the following key guidance provided by the HKMA.

Topic of Concern	HKMA Guidance
Custodial Arrangement	AIs that provide custodial services of tokenized products should meet the expected standards on digital asset custody issued by the HKMA. AIs should consider the most appropriate custodial arrangement taking into account the features and risks of the tokenized products, including the relevant considerations where permissionless tokens on public-permissionless distribution ledger technology (DLT) network are used.
Disclosure to Clients	AIs should disclose material information on the tokenization arrangement. Examples risks posed by the DLT network used possible lack of interoperability of the DLT network with other networks or infrastructures vulnerability to cybersecurity threats, such as hacks and security breaches any limitations imposed on transfers of the tokenized product risks related to the use of smart contracts potential legal uncertainty around areas such as ownership rights and settlement finality on a DLT network
Tokenization Arrangement	If AIs issue or are substantially involved in the issuance of a tokenized product, It should take into account considerations regarding due diligence on the issuers and third-party vendors/service providers. It should include whether and how the new risks relating to ownership and the underlying technology of the tokenized products are managed. There should be appropriate arrangements for technology audits (in particular, smart contract audits) as well as formulation of proper policies and procedures with regard to operation of the tokenized products.
Internal systems and controls	AIs should implement appropriate systems and controls (including adequate administrative control) with regard to operation of the tokenized products, such as private key management and safeguards against theft, fraud, errors and omissions, hacking, and other cybersecurity risks. There should also be effective contingency plans in the event of, for example, DLT network failure, cyber-attacks, unauthorized transfer, and loss of private keys for access to tokenized products.

Given that both the SFC and HKMA have issued guidance to the industry on their expected conduct requirements, this resonates with our earlier observation that there would be increasing inter-regulatory cooperation among regulators. This growing trend of regulatory engagement will have a significant impact on market participants’ risks assessment of doing business in Hong Kong and how the joint regulatory efforts would translate Hong Kong as the optimal choice of jurisdiction for financial intermediaries interested in participating in the tokenization process and/or VA space.

Appendix
HKMA’s Fintech Initiatives Relating to Payments

HKMA Initiative	Overview	Potential Impact
2023
May 18 — Commencement of the retail central bank digital currency e-HKD Pilot Programme [Phase 1]	collaboration with stakeholders to examine use cases implementation and design issues relating to e-HKD plans to establish a CBDC Expert Group	help to enrich HKMA’s perspective refine HKMA’s approach to the possible implementation of e-HKD contribute valuable insight to support HK’s future exploration on key policy and technical issues surrounding CBDC
October 20 — HKMA signs memoranda of understanding with five local universities to foster collaboration on CBDC research = CBDC Expert Group	support HKMA’s exploration of key policy and technical issues surrounding CBDC offer advice, training sessions, and workshops pertaining to CBDC and related fintech topics to the HKMA	research paper on privacy issues pertaining to CBDC to examine the efficacy of different types of privacy-enhancing technologies research paper on interoperability of CBDCs to examine the viability of blockchain technologies and related standards in facilitating compatibility between different CBDC implementations
October 30 – HKMA publishes the “e-HKD Pilot Programme Phase 1 Report”²⁵	discusses key findings, lessons, and HKMA’s assessment of 14 pilots assessed sets out next steps of the e-HKD Pilot Programme	E-HKD: could add unique value to current payment ecosystem in three main areas — programmability, tokenization, and atomic settlement has potential to facilitate faster, more cost-efficient, and inclusive transactions could enable new types of economic transactions
2024
March 7 — Project Ensemble	focus on tokenized deposits form wCBDC Architecture Community (Community) partner with Cyberport and Hong Kong Science and Technology Parks Corporation to foster the development of asset tokenization and support homegrown fintech innovation collaborate with BIS Innovation Hub Hong Kong Centre on projects like Project Genesis	To build on the experimentation of tokenized deposit use cases to extend invite to engage relevant international stakeholders, other central banks, and organizations garner sufficient interest from the industry, to conduct “live” issuance of wCBDC in due course
March 14 — HKMA launches Phase 2 of the e-HKD Pilot Programme	build on success and experience of Phase 1, Phase 2 will delve deeper into select pilots to explore new use cases for e-HKD to add unique value, namely programmability, tokenization, and atomic settlement enhanced e-HKD Sandbox will support Phase 2 and among others, to facilitate the study of interoperability and interbank settlement between e-HKD and other forms of tokenized money	These research will underpin HKMA’s role in exploring the role of CBDCs in the future digital money landscape facilitate HKMA’s study on the possible implementation of an e-HKD
May 7 — HKMA establishes Project Ensemble Architecture Community	shape standards and provide suggestions to support the development of Hong Kong’s tokenization market make recommendations on initially focusing on establishing a mechanism to support seamless interbank settlement of tokenized deposit through wCBDC for tokenized asset transactions	The Community aims to develop a set of industry standards to support interoperability among wCBDC, tokenized money, and tokenized assets assist in design and implementation of the Project Ensemble Sandbox to facilitate further research and testing of tokenization use cases
June 27 — Collaboration between Banque de France and HKMA unlocks new CBDC cross-border opportunities	two central banking institutions entered into a memorandum of understanding to foster innovation in wCBDC and tokenization market agree to strengthen communication and collaboration and to lay the foundations for further efforts on tokenization and new technologies	explore opportunities on different use cases for payment versus payment between the tokenized form of Hong Kong dollar and the Euro explore different cross-border payment solutions and use cases to promote financial market connectivity and push forward development of the global tokenization market

¹ 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/.
² Project Genesis is Bank of International Settlement (BIS) Innovation Hub 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. BIS issued three project reports in November 2021 below:
*Report 1: https://www.bis.org/publ/othp43_report1.pdf
*Report 2: https://www.bis.org/publ/othp43_report2.pdf
*Report 3: https://www.bis.org/publ/othp43_report3.pdf
3 Page 22 of Report 2 states, “As digital assets are managed in a digital ledger representation, it quickly becomes apparent of the need for a digital equivalent of payment.”
⁴ Hong Kong Fintech Regulatory Update: From “A Leap of Faith” to “A Vote of Confidence” Part I Expanding Clientele (Retail Access).
⁵Joint circular on intermediaries’ VA-related activities on December 22, 2023 (Joint Circular): https://apps.sfc.hk/edistributionWeb/gateway/EN/circular/doc?refNo=23EC67.
⁶ This table supersedes the table set out in the Sidley article referenced in footnote 4.
⁷ See footnote 5 above.
⁸ There are four types of professional investors: (a) “Institutional professional investor” is defined under paragraph 15.2 of the Code of Conduct for Persons Licensed by or Registered with the SFC (Code of Conduct) as persons falling under paragraphs (a) to (i) of the definition of “professional investor” in Section 1 of Part 1 of Schedule 1 to the SFO; (b) “qualified corporate professional investors” refers to corporate professional investors that have passed the assessment requirements under paragraph 15.3A and gone through the procedures under paragraph 15.3B of the Code of Conduct; (c) “nonqualified corporate professional investors” — please refer to footnote 10 below; and (d) “individual professional investors” — please refer to footnote 11 below.
⁹ The nonexhaustive list of examples of noncomplex and complex products can be found at https://www.sfc.hk/en/Rules-and-standards/Suitability-requirement/Non-complex-and-complex-products.
¹⁰“Nonqualified corporate professional investors” refers to corporate professional investors that have not passed the assessment requirements under paragraph 15.3A or have not gone through the procedures under paragraph 15.3B of the Code of Conduct.
¹¹ “Individual professional investors” refers to individuals falling under Section 5 of the Securities and Futures (Professional Investor) Rules.
¹²VA-related products refer to exchange-traded funds (VA ETFs), VA ETPs, funds (VA funds), and derivative products (VA derivative funds, VA derivative ETPs, and VA-related derivative products) that meet the following criteria: (a) have a principal investment objective or strategy to invest in VA, (b) derive their value principally from the value and characteristics of VA, or (c) track or replicate the investment results or returns that closely match or correspond to VA.
¹³ (a) Paragraph 5.5 of the Code of Conduct; (b) for derivative products, compliance with Paragraphs 5.1A and 5.3 of the Code of Conduct; (c) Chapter 6 of the Guidelines on Online Distribution and Advisory Platforms; and (d) Frequently Asked Questions on Compliance with Suitability Obligations by Licensed or Registered Persons and the Frequently Asked Questions on Triggering of Suitability Obligations. In particular, intermediaries should diligently assess whether the nature and features of VA-related products are suitable for the client and are in the best interests of the client, taking into account the client’s risk tolerance, financial situation, etc. and also conduct proper due diligence on VA-related products.
¹⁴ A flowchart illustrating the factors for determining whether a VA-related product is a complex product is set out in Appendix 3 of the Joint Circular.
¹⁵ Nonexhaustive criteria for assessing whether a client can be regarded as having knowledge of VA are set out in Appendix 1 of the Joint Circular.
¹⁶ See footnote 10.
¹⁷ See footnote 11.
¹⁸ Additional due diligence requirements for non-SFC-authorized VA funds.
¹⁹ List of regulated specified exchanges is set out in Schedule 3 to the Securities and Futures (Financial Resources) Rules (Cap. 571N, Laws of Hong Kong) and the SEHK.
²⁰ List of designated jurisdictions appear in Appendix 2 to the Joint Circular.
²¹ Examples of risk disclosure statements specific to VA appear in Appendix 5 of the Joint Circular.
²² Subject to compliance with guidance set out in the Tokenized Products Circular.
23 For example, the Code on Unit Trusts and Mutual Funds: https://www.sfc.hk/-/media/EN/assets/components/codes/files-current/web/codes/section-ii-code-on-unit-trusts-and-mutual-funds/section-ii-code-on-unit-trusts-and-mutual-funds.pdf?rev=b03aa74178af41c48da5f21ae2f3fb6b.
²⁴ HKMA’s circular on sale and distribution of tokenized products dated February 20, 2024: https://www.hkma.gov.hk/media/eng/doc/key-information/guidelines-and-circular/2024/20240220e2.pdf.
²⁵ Link to the report: https://www.hkma.gov.hk/media/eng/doc/key-information/press-release/2023/20231030e3a1.pdf.

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