The government will enact the new legislation to bring issuers of fiat-referencing stablecoins into the regulatory perimeter.

On 17 July 2024, the Financial Services and the Treasury Bureau and the Hong Kong Monetary Authority (HKMA) released the consultation conclusions on their legislative proposal for a regulatory regime governing stablecoin issuers in Hong Kong (Consultation Conclusions). The next day, the HKMA followed with its own press release announcing the first batch of three participants admitted to the stablecoin issuer sandbox (Sandbox) launched in March 2024.

This blog post summarises the key updates set out in the Consultation Conclusions regarding the proposed Hong Kong regulatory framework, as well as next steps for issuers of fiat-referencing stablecoins (FRS) who may fall within scope of the regime or are interested in participating in the Sandbox.

Background

The Consultation Conclusions follow the consultation paper (Consultation Paper) released in December 2023 (see Latham’s blog post) outlining the government’s initial proposal to establish a legislative framework governing stablecoin issuers. The Consultation Conclusions clarify and amend certain aspects of the proposed regime in response to feedback received.

Hong Kong’s Consultation Conclusions come as other jurisdictions and international standard-setting bodies accelerate their work to bring stablecoins within the regulatory perimeter. For example, the European Union’s rules governing stablecoins (categorised as asset-referenced tokens and e-money tokens) in the Markets in Crypto-Assets Regulation came into effect on 30 June 2024, while on 17 July 2024, the Basel Committee published its final disclosure framework for banks’ cryptoasset exposures and targeted amendments to its cryptoasset standard.

Updates to the Proposed Regulatory Approach Governing Stablecoin Issuers

The HKMA received more than 100 submissions to the Consultation Paper from a variety of market participants, industry associations, and business and professional organisations. In response to the feedback received, the Consultation Conclusions contain a number of key clarifications and updates:

• Focus on stablecoins operated on decentralised ledgers. Respondents queried whether the stablecoin definition would cover stablecoins operating on a digital ledger controlled by a single party (e.g., a private blockchain).
  The HKMA suggested amendments to the definition of “stablecoin” to clarify that the scope is intended to cover stablecoins that are “operated on a decentralized distributed ledger or similar technology” (i.e., a distributed ledger in which no person has the unilateral authority to control or materially alter its functionality or operation).
• Scope of “issuance” activities to be clarified in guidelines. Respondents generally agreed with the HKMA’s approach to target stablecoin issuers, but asked for additional clarity on what would constitute the activity of “issuance”.
  The HKMA confirmed that the assessment will be made on a case-by-case basis. It intends to provide further guidelines to the industry upon implementation of the licensing regulation regime.
  Although the provision of wallet services is not regulated under the stablecoin regime, the HKMA noted that the government and financial regulators are considering the regulatory framework around the storage of private keys and the provision of wallet services. The HKMA has separately issued guidance for banks providing custody services (see Latham’s blog post).
• Licensing scope confirmed. Under the proposed licensing scope, all FRS issuers that (1) issue FRS in Hong Kong, (2) issue a stablecoin referencing the Hong Kong dollar, or (3) “actively market” the issuance of FRS to the Hong Kong public will be required to obtain a licence with the HKMA. Therefore, any person (including issuers, agents, and intermediaries) will commit an offence when promoting unlicensed FRS issuance. However, agents or intermediaries actively marketing a licensed FRS issuance will not be considered as stablecoin issuers, and therefore are not required to obtain a licence.
  Determining whether an FRS is issued in Hong Kong will depend on the facts and circumstances of each case. Relevant factors will include the FRS issuer’s place of incorporation, the location of its operations, provision of subsequent customer service to FRS users, and whether a Hong Kong bank account is used to process the issuance and redemption requests. The HKMA intends to issue further guidelines on this.
• Composition of reserve assets clarified. FRS issuers will be required to ensure that FRS in circulation are fully backed by high-quality and highly liquid reserve assets at all times. The HKMA noted it will adopt a risk-based regulatory approach and require FRS issuers to demonstrate how their investment policies meet the size and complexity of their business.
  The HKMA clarified that the composition of reserve assets may 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 organisations with high credit quality, (d) overnight reverse repurchase agreements with minimal counterparty risk backed by these securities, and (e) tokenised versions of the above assets. The latter category is forward-looking and helpful in clarifying that tokenized financial assets could qualify as reserve assets for FRS issuer.
  Reserve assets should generally be held in the same currency as that referenced by the FRS. If a currency mismatch occurs between the referenced currency and the reserve assets, FRS issuers will need to obtain prior approval from the HKMA. In such cases, the HKMA may impose additional requirements, such as over-collateralisation. However, for HK$-referenced stablecoins, FRS issuers will be allowed to include US$-denominated reserve assets (as HK$ is pegged to US$), which is a helpful clarification.
• Safekeeping reserve assets in other jurisdictions may be permitted. FRS issuers will be required to safekeep reserve assets under arrangements accepted by the HKMA. The HKMA will consider proposals from licensed FRS issuers on placing the reserve assets in jurisdictions outside of Hong Kong on a case-by-case basis, provided that issuers can demonstrate the need for the arrangement and mitigate the relevant risks without compromise to user interests.
• Segregation and trust arrangements on reserve assets. The HKMA clarified that for an “effective trust arrangement” of reserve assets, it expects the appointment of an independent trustee or a declaration of trust over the reserve assets. Prior to implementation, an FRS issuer should submit a draft of the relevant trust deed together with a draft of an independent legal opinion for the HKMA’s review.
• Monthly attestation required, but reduced frequency of disclosure of FRS and reserve assets. The HKMA is inclined to uphold its proposed requirement of monthly attestation on reserve assets conducted by a qualified and independent auditor. Detailed guidelines will be subject to further discussion with stakeholders.
  However, following views from the market, the HKMA is inclined to reduce the frequency of disclosure with respect to the total amount of FRS in circulation, as well as the market value and composition of reserve assets (the previous proposal suggested at least daily and weekly disclosure, respectively). Again, detailed disclosure requirements will be announced following further consultation by the HKMA.
• Timely fulfilment of redemption requests. The HKMA clarified that under normal circumstances, redemption requests will need to be fulfilled within one business day after the day on which a redemption request is received in order to meet the “timely” processing requirement. In the case of extraordinary circumstances that may delay the process, FRS issuers shall seek the HKMA’s approval.
• Requirement for physical presence in Hong Kong is maintained (except for banks). Although some feedback argued for a more flexible approach for global issuers, the HKMA stated that it will keep in place its requirement for local incorporation of FRS issuers. Therefore, any non-Hong Kong incorporated companies (other than authorised institutions incorporated outside Hong Kong) intending to apply for a licence will be required to establish a subsidiary in Hong Kong.
• Adjusted financial resources requirement. The Consultation Paper proposed the minimum paid-up share capital to be the greater of HK$25 million and 2% of the total FRS in circulation. In response to feedback, the new capital requirement will be set at HK$25 million or 1% of the par value of FRS in circulation, whichever is higher. The HKMA will also maintain the power to impose additional paid-up share capital requirements as licensing conditions where necessary.
• Transitional period of six months. Since the HKMA has been actively liaised with market participants already (including through the Sandbox), it considers that a transitional period of six months will be reasonable and sufficient.

Restrictions on Offering of FRS

The Consultation Paper previously proposed that only certain Hong Kong-licensed entities (e.g., licensed FRS issuers, banks, securities firms, and virtual asset trading platforms) can offer or actively market FRS in Hong Kong. “Offer” 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”. Any FRS issued by entities not licensed by the HKMA will only be permitted to be offered to “professional investors”.

Market participants suggested implementing cross-jurisdictional mechanisms (e.g., passporting or mutual recognition arrangements) to facilitate FRS issuers licensed elsewhere to be offered in Hong Kong. The HKMA noted that it may, in the future, consider formal regulatory cooperation mechanisms with other jurisdictions as and when equivalent regimes are established. The HKMA will stay in close dialogue with its international counterparts. However, whether or how these potential mechanisms will be built into the proposed legislative framework remains unclear.

Sandbox

In March 2024, the HKMA launched a Sandbox for proposed stablecoin issuers. The HKMA noted that it received significant interest, and it has selected three participants for the first batch admitted to the Sandbox.

While the HKMA has purposely set the admission bar to the Sandbox at a reasonably high level in order to facilitate effective operation of the Sandbox, admission to the Sandbox is not a prerequisite to obtaining a licence when the legislative framework comes into effect. Within the Sandbox, participants can test their proposed business models safely within a limited scope.

Through the Sandbox, the HKMA wants to better understand concrete use cases for stablecoins. The HKMA noted that the primary use cases proposed by the first batch of participants include payments, supply chain management, and applications in capital markets. Use of stablecoins is intended to lower costs, reduce transaction time, and leverage programmability features with potential application towards not only financial services, but also other areas such as Web3, gaming, and virtual asset trading.

The HKMA noted that Sandbox participants will be able to test out their stablecoin issuance process so that the HKMA can understand how issuers would be able to mitigate risks and comply with the proposed regulatory framework. Given the cross-border nature of payments, participants are expected to demonstrate that they can strictly comply with the applicable laws and regulations in other jurisdictions where they operate.

Currently, Sandbox participants must not raise funds from the public or offer any investment products in the name of the Sandbox. They also cannot use the general public’s funds at the initial stage of their testing. However, later on, the HKMA will separately announce whether Sandbox participants are allowed to handle the general public’s funds within a limited scope as a result of adjustments to the testing scope.

Next Steps

Currently, the regulatory proposal is being drafted into a bill, which will be introduced to the Legislative Council later this year. The HKMA has noted that it will, in due course, issue licensing and supervisory guidelines to facilitate applicants’ understanding of, and compliance with, the regulatory framework.

Applicants interested in participating in the Sandbox can contact the HKMA to consider their suitability for involvement.

Latham & Watkins will continue to analyse and report on the new developments to the Hong Kong stablecoin regulatory framework.