II. Background
A. Definition and Taxonomy
There is no universal consensus about the precise definition of stablecoins. Regulators such as central banks focus more on the potential effect of stablecoins on the financial system, thus, including any digital asset with a price stabilization mechanism not issued by central banks into the definition. One major function of stablecoins is to provide a stable value and enable cryptoassets, which are commonly regarded as volatile investment products, to serve as a steady payment method. Due to the high price validity, cryptoassets cannot fulfill the traditional functions expected for a payment medium, such as a store of value, a means of payment, and a unit of account. Stablecoins are designed in response to the challenge and recent development shows that stablecoins issuers intended to apply this type of cryptoassets as a payment method in global transactions. The idea of offering cryptoassets with stable value has a huge impact on the financial market and has created heated discussions among regulators and practitioners.
Issuers of stablecoins can be cryptoasset-related business entities as well as existing financial services providers. For example, PayPal offers a stablecoin (PYUSD) to US customers who have PayPal accounts. In order to compete with other stablecoins, those financial services providers might utilize their existing business ecosystem to offer better terms and services. In the case of PayPal, it does not charge customers any fees for buying and selling PYUSD to the issuer, which can make it more attractive for existing PayPal account holders to use PYUSD. Among all stablecoins, the stablecoin issued by a platform named Tether (USDT) is one of the most commonly used tokenized stablecoins in the world. USDT was promoted to the market in 2014 and enjoyed a first-mover advantage by holding a majority of the market shares. In 2018, USDT took a dominant position by holding more than 99% of the total market shares of all stablecoins. But, regulators in the US charged Tether with misrepresentation about its asset holding in 2021 and the incident was a severe blow to investors’ confidence in the product. The market share of USDT saw a significant drop from 99% in 2018 to 66% in 2023.
According to the design of stablecoins, they can be divided into four types including tokenized funds, off-chain collateralized stablecoins, on-chain collateralized stablecoins, and algorithmic stablecoins. The tokenized fund is supported by a single fiat currency or a basket of currencies. Issuers offer stablecoins in exchange for fiat currency. Through custodian arrangement, customers can ask for redemption in accordance with the refund policy. Both off-chain and on-chain collateralized stablecoins peg with other recognized assets. The difference is the custodian arrangement for the collateral. If the referred assets are managed without the blockchain, then they will be categorized as off-chain collateralized stablecoins. If underlying assets are recorded on the blockchain (such as other cryptoassets), they are treated as on-chain collateralized stablecoins. Finally, the algorithmic stablecoin does not refer to any particular asset, instead, issuers utilize a computer algorithm to continuously monitor the supply and demand of the stablecoin and maintain the price by minting more coins in response to high demand or burning extra coins to cut supply (see more discussion in Section 2.2).
Different types of stablecoins entail various responsibilities of the issuers. For tokenized funds that are supported by fiat currencies, since the issuance and redemption processes involve exchanges of fiat money and stablecoins, the issuers are responsible for managing customers’ funds and ensuring the safety of the transactions. Upon receiving fiat money from customers, the issuers will record the transaction on the distributed ledger which might represent a legal claim against the issuer (the types of legal rights depend on service terms). The issuers will make a custodian arrangement by either holding fiat currencies by themselves or delegating the safekeeping function to a third party. Issuers apply smart contracts to transfer stablecoins to customers in the issuance and redemption process and customers can also use smart contracts to conduct money transfers with other users.
Both off-chain and on-chain collateralized stablecoins have similarities with tokenized stablecoins as the value of the cryptoassets is supported by other assets. Unlike tokenized stablecoins which return the same amount of fiat currency at redemption, collateralized stablecoins might not have the underlying assets at the same value when customers require redemption. To protect the interest of the issuers and customers as a whole, issuers will ensure that the value of the underlying collateral is always maintained equal to or larger than the par value of the stablecoins. In other words, the value of the collateral is higher than the stablecoins in circulation. Furthermore, the issuers may request customers to add assets in case the price of the collateralized asset declines. At the same time, the liquidity of the asset is a key consideration for issuers to actualize the value, therefore, issuers can accept only specific types of assets that are popular in the secondary market (such as treasury bonds or stock). But, due to the decentralized operation model, issuers have difficulty in managing off-chain collaterals which cannot be stored or recorded on the distributed ledger. For example, issuers are reluctant to accept real estate as underlying assets since the management of real estate can be more complex than digital assets, and the proof of legal title of real estate has to be in written form and registration requirement is common in many jurisdictions. Such legal impediments can slow the transaction and cause extra costs.
Finally, the industry has developed a completely different type of stablecoins called algorithmic stablecoins, which might not conceptually fit into some observers’ definition of stablecoins. Because the algorithmic stablecoins might not be supported by other assets, the price stabilization mechanism is opaque to investors. The price of stablecoins is adjusted through an arbitrage process which might be executed by other investors or smart contracts set up by issuers. Take TerraUSD (UST) as an illustration. UST is an algorithmic stablecoin pegged with another stablecoin Luna, which is also developed by the same issuer. In this case, UST does not directly link with fiat currency but another stablecoin. One unit of UST can be exchanged for USD 1 worth of Luna and vice versa. Price stabilization is achieved through the arbitrage opportunity when the price of UST fluctuates. For example, if the current price of UST is lower than USD 1, then investors can use fiat currency or other assets to purchase one unit of UST at a price lower than USD 1 and then convert this unit into USD 1 worth of Luna, which will increase the demand for UST and increase its value. The investor would sell UST in a similar manner when the price goes beyond USD 1. Apart from investors, the smart contract can intervene at the same time by selling its reserves of other assets and purchasing exceeding UST from the market and then burning them, which will decrease the supply of the coin and then boost the price. To further enhance the stability of algorithmic stablecoins, issuers also apply other policies to better control the supply and demand of coins. Issuers can set exit restrictions by charging redemption fees or daily redemption limits, or create incentives for holding the coin.
B. International Context: Rapid Development with Increasing Concerns
Stablecoins received wide popularity in many jurisdictions due to their convenience in payment and lesser regulation. According to statistics, at the end of 2023, there were more than 100 types of stablecoins in circulation with a total market capitalization exceeding USD 127 billion. Many widely used stablecoins are pegged with the US dollar and other fiat currencies, including the euro and Hong Kong dollar. But the lagged regulation cannot properly respond to the rapid development and there are several serious incidents which caused a huge impact on the market confidence.
1. Collapse of Terra
The cryptoasset industry probably would agree that the most prominent stablecoin incident in 2022 is the collapse of the UST coin and its issuer, Terra, which was at that time, one of the largest cryptoasset platforms. Investors witnessed a shock collapse in only three days with more than USD 40 billion in assets wiped out. The stablecoin was developed by a South Korean cryptoasset entrepreneur, Do Kwon, and his associates in 2018. With the great success of UST, Do Kwon quickly became one of the most successful crypto tycoons controlling more than USD 40 billion worth of assets.
As discussed in Section 2.1, Terra issued twin stablecoins (UST and Luna) and designed a complex price stabilization mechanism to maintain its value. In its growing stage, it was not an easy task for investors to understand the mechanism let alone spot the potential danger for systemic failure and price collapse. Investors only gradually realized that the value of the UST depends on confidence in the system. If investors lost faith in the value of UST, they would convert a large amount of UST into Luna, which then would lead to an increase in the Luna supply and a significant decline in Luna price. For any existing holder of Luna, seeing an incoming price plummet, the only rational action is to sell Luna holdings at the current best price. The panic selling of Luna can be a deadly blow to the system, resulting in a “death spiral” of value for both UST and Luna. Scholars argue that the expansion of the usage can increase the fragility of the system. With more UST in circulation, the system is more vulnerable to failure. But the hazard in the system did not receive enough attention. Instead, Terra adopted another unsustainable arrangement to boost the supply of UST. The company developed a borrowing and savings platform called Anchor, which allowed holders of UST to deposit their stablecoin into the platform and receive interest. The interest rate is very attractive and higher than other platforms. Investors did not question the 19.5 percent interest rate and were happy to purchase more UST. It did not take a long time before the company drastically adjusted the interest rate in March 2022, showing that the fees and other income could not support the high yield.
Another alarming incident worrying regulators is the handling method of Terra in the face of the decrease in the value of UST in 2021. In May 2021, the price of UST dropped below USD 1 and soon regained stabilization. Investors later found out that the major contribution to the price restoration was not the “algorithmic function” but the intervention by a third party engaged by the platform, which injected funds to save the market. Without a proper understanding of the stabilization system and efficient supervision, the company can make misrepresentations or fraudulent statements to investors, claiming that the stabilization system can automatically balance the supply and demand in a decentralized manner and resist market turbulence.
2. Regulatory Responses
In response to the regulatory loopholes, major economies proposed various measures to put stablecoins under reins. For example, the EU regulators proposed a comprehensive framework and set a much higher requirement for issuers of stablecoins than other cryptoassets. In addition to higher licensing requirements, the EU also extended the definition of the e-money token to ensure that all investors of the stablecoins will enjoy a legal claim on the issuers. To ensure the accuracy of disclosed information, the regulation further describes the authorization process for stablecoin issuers and the approval of their white papers by the national competent authority, the withdrawal of authorization, and the procedure for modifying the cryptoasset white paper.
Contrary to the detailed framework implemented in the EU, the US regulators tended to take more time for observation before finalizing the regime. In December 2020, the US President’s Working Group on Financial Markets (PWG) published a statement providing an initial assessment of major regulatory and supervisory considerations. While encouraging payment innovation, PWG emphasized that “digital payment systems, including stablecoin arrangements, should be designed and operated in a responsible manner that effectively manages risks and maintains the stability of the US domestic and international financial and monetary systems.” One year later, the PWG released the final discussion result about stablecoins, in which the PWG called for Congress to enact sweeping new laws to regulate stablecoin issuers, wallet providers, and related entities, citing the pressing risks of destabilizing runs, disruptions in the payment system, and concentration of economic power. But legislators in the US have not finalized the framework and there is no legislation on stablecoins at the federal level.
At the same time, some regulators focused their attention on some aspects of activities or certain types of stablecoins for better utilization of resources. Singapore can be an example. Singapore has a single regulator in the financial market, the Monetary Authority of Singapore (MAS), which supervises all financial activities conducted within the jurisdiction. The regulator sees single-currency stablecoins as the most promising product that can serve as a credible digital medium of exchange and can be used in the payment system with a high degree of assurance of value stability. Therefore, based on the taxonomy discussed above, only tokenized funds have a chance to be included in the single-currency stablecoin scheme and enjoy special attention, while other types of stablecoins will continue to be regulated as “digital payment tokens.” In addition, even among single-currency stablecoins, there is variation in the stabilization mechanism and the MAS plans to be rigorous to check the stabilization arrangement and weed out stablecoins that are susceptible to volatility in value.
III. Reasons for HKMA’s Recent Initiative
A. The Political Economy Context
1. Hong Kong’s Goal as a Cryptoassets Hub
Although most of the stablecoins in circulation are pegged with US dollars, many prominent stablecoins issuers and cryptoassets exchange platforms founded their companies in Hong Kong. In 2019, a platform called Bitspark proposed to issue a stablecoin backed by the Hong Kong dollar. As the crypto market in Hong Kong becomes more mature, there are more companies interested in operating business in Hong Kong or targeting Hong Kong-based investors. Apart from active participation from the crypto industry, universities and other IT companies also agree that the development of stablecoins is an important topic in Hong Kong’s pursuit of digital asset development, applauding its function “as a bridge between traditional finance and the digital economy.” Recently, a research team led by the vice president of Hong Kong University of Science and Technology suggested that the Hong Kong government shall take the lead and issue a stablecoin pegged to the Hong Kong dollar.
As an international financial center, Hong Kong is open and inclusive towards the global community of innovators engaging in cryptoassets businesses. Hong Kong has witnessed the achievements of the crypto industry in pioneering distributed ledger technologies (DLT) and in developing new financial innovations including stablecoins. But the existing framework does not properly reflect the need for a technology-friendly environment. Therefore, the Hong Kong government issued an overall policy statement on the development of cryptoassets in 2022, stating the grand plan to build Hong Kong into a global fintech hub.
2. Possible Regulation Competition with the SFC
Hong Kong adopts a sector-based regulatory arrangement in financial regulation where the Hong Kong Monetary Authority (HKMA) acts as the central bank and the supervisor for prudential management and the Securities and Futures Commission (SFC) oversees the securities market. Therefore, the unclear legal definition of stablecoins has already caused regulatory confusion in the beginning. For example, some stablecoins can be used as payment methods or financial investment products, then they might be monitored respectively by the HKMA as stored value facilities or by the SFC as securities. But many stablecoins do not squarely fit the narrow definition provided by either agency, leaving them in an unregulated position. The HKMA has noticed that the linkage with other assets makes stablecoins different from other types of cryptoassets. Particularly, many stablecoins demonstrate a potential to become a means to store value and make payments, and the HKMA sees a higher potential to incorporate them into the mainstream financial system and use them in the cross-border payment system. Customers would consider the possibility of incorporation of stablecoins into the mainstream financial system or even day-to-day commercial and economic activities. Therefore, stablecoins could have a more direct impact on the monetary and financial systems.
Observers sometimes conclude that Hong Kong regulators are inclined to adopt a wait-and-see approach towards emerging financial products. But in the case of regulation on cryptoassets, the SFC has provided a comprehensive licensing regime ahead of the HKMA. The SFC promulgated its first statement on the regulation of cryptocurrency-related investment products in 2017 and the voluntary opt-in regulatory regime for the virtual asset trading platform (VATP) came nearly a year later. In 2022, the SFC included all centralized VATP’s into the compulsory licensing regime which was put into implementation in the middle of 2023. Practitioners welcome the new regime, citing that the framework is supportive of the underlying innovative technology and the growth of the fintech community in Hong Kong. Two VATP’s have successfully obtained licenses to provide trading services to Hong Kong investors and seven more platforms submitted applications. Surely it would be imprudent to conclude that the HKMA is competing with other regulatory agencies in designing a framework since the regulatory subjects are different. But crypto-related companies and investors might take a different view, worrying that hesitation and inaction might impede the development of stablecoins and leave ongoing impropriety without effective regulation.
The HKMA’s close watch on the development of its regulatory counterparty also demonstrates that cooperation and proper alignment are important. The HKMA often mentions the progress of the SFC in regulating other types of cryptoassets in its own statement. From the speeches of its top executives, the HKMA is fully aware that investor protection and supervision would be less efficient without its framework on stablecoins.
B. The Inadequacy of Current Regulation
1. Existing Regulatory Tools Cannot Cover All Stablecoins
Under the existing framework, the financial products bearing the most similarity with stablecoins are the stored value facilities, including e-wallets and prepaid cards. But there are conceptual and legal obstacles to applying stablecoins into the stored value facilities regime. According to the definition, a stored value facility needs to store the value of an amount of money and can be paid for services or transferred to other users. Preliminary observation can identify several potential difficulties. First of all, the stablecoins might not reflect the value of the money paid into the facility, since the value of the stablecoins fluctuates. It can be argued that stablecoins cannot represent the money invested. Then the issuer of stablecoins might only designate a narrow range of usage and prohibit to use of the stablecoin as a means of payment for any third party. This may render the stablecoin arrangement not a stored value facility even though when viewed in its totality, they operate in a similar manner.
2. Confusion in Legal Definition
Issuers of stablecoins try to direct public attention to focus on the innovative aspect of their products, instead of addressing the necessary legal implications of the new financial products. Issuers often avoid providing clear categorization of stablecoins but reassure customers that stablecoins are solutions to challenges faced by the international financial market and essential elements for the future of a decentralized payment system. But regulators observe the rapid development with great concerns about whether stablecoins can rightly fit into existing regulations or a new regime has to be set up for the creation.
For example, a stablecoin pegged with fiat currency can be treated as electric money, stored value facility, pegged currency, or a new form of financial product. Various categorizations entail completely different regulatory regimes which will cause confusion and potential loopholes. Given the decentralized operation model, the issuers of tokenized stablecoins might not fall within the definition, impeding regulators from effectively applying the existing framework to stablecoins. If regulators do not stretch the definition in the existing framework to fit stablecoins, then stablecoins can create similar risks as other payment methods with meaningful regulation. The issue can be more complex in defining algorithmic stablecoins. Since the value of algorithmic stablecoins is not fully backed by other assets, they can hardly be categorized as a digital representation of monetary value, thus, investors may not have the same legal claim on the issuers as regulated electronic money.
As for the anti-money laundering challenge, different financial products receive varying levels of scrutiny, and it is a common case that financial products used as payment methods are one of the major supervision categories while other products might have lesser requirements. Issuers of stablecoins might leverage such discrepancy and create regulatory arbitrage.
3. Reliability of Stabilization System
The value of stablecoins, regardless of which stability mechanism the issuer chose, will inevitably fluctuate in the market and the stabilization process might harm the interest of investors. For example, collateralized stablecoins require every investor to put sufficient assets to maintain the value. But investors might suffer from losses resulting from the failure of other investors to provide collateral. Since all assets will be pooled together and the value of the stablecoin is determined by the total value of the asset pool, the price can fall even though individual customers hold their obligation to provide enough assets. The situation can be more serious in terms of stablecoins using other cryptoassets as reserves. The high volatility of cryptoassets increases the difficulty of maintaining the price. Given the intercorrelation among cryptoassets, it would be harder to find a suitable buyer in a dire market.
Investors may not fully understand the operation model of stablecoins due to a lack of information, incomprehension of technical details, or misrepresentation. It is an essential task for regulators to scrutinize all technical details before allowing stablecoins to be offered to investors. Supporters for lesser regulation on stablecoins might worry that excessive information disclosure requirements could hold the development process back, calling for a relaxing framework and self-regulation. Though some issuers claim that their mechanism design has sufficient transparency and potential investors shall be able to fully understand the technical and financial implications of the stablecoin before making the decision, such a statement ignores the reality and shifts unreasonable responsibility to retail investors. Unlike traditional financial products such as stocks and bonds, there is no mature regulatory framework on stablecoins and retail investors cannot effectively protect themselves through the disclosure process. In the absence of professional intermediaries and a strong enforcement scheme, it would be difficult to expect retail investors to have enough resources to guard their interests.
4. Fund Mismanagement and Lack of Supervision
Though fund mismanagement issues repeatedly raise investors’ concerns for many investment products, it is a more serious challenge for issuers of stablecoins as confidence in the value largely depends on whether the issuers have sufficient funds to support the stablecoins. And the performance of many stablecoin issuers was not satisfactory. For example, the most widely used stablecoin, Tether, uses multiple financial institutions in Puerto Rico and the Bahamas to handle clients’ funds. Tether claimed that all the issued stablecoins are fully backed by the US dollar, and holders of Tether can redeem stablecoins from the company at the rate of one Tether for one US dollar. But the US regulators found out that at several junctures Tether was not fully backed by sufficient assets and there was a clear sign of reserve shortage. On one occasion, in order to counter allegations from the market that the stablecoin was not backed by sufficient funds, the platform engaged an accounting firm to perform account verification. The verification has been criticized as a sham because the accountant only checked the account at a specific point in time. And it turned out that Tether only transferred the required amount of money from a related party on the same day morning. Another case of misleading statements about fund reserves happened in 2018. Tether and its operator entrusted a third party to handle company funds but they encountered difficulty in withdrawing money from the third party. In order to meet the liquidity needs of the platform, it successfully obtained a line of credit of USD 475 million drawn from the clients’ fund reserves. This case demonstrated severe internal control loopholes and potential misuse of clients’ funds which shall be separated from the company’s assets. Apart from complaints issued by the state regulators, the regulators at the federal level also took regulatory action against the misrepresentation of the sufficiency of assets.
The ex-post regulatory approach adopted by regulators can be harmful not only to investors but also to the long-term development of the crypto industry. Shall the regulatory action be only triggered if platforms encounter financial distress, then the system would be more vulnerable to severe failure. Given the global operation of the stablecoin platforms, the later intervention by regulators might not be sufficient to protect clients’ money. Banning platforms from future services to local investors, which has been adopted by many regulators, can hardly remedy the huge loss. Recent cases clearly demonstrate the need for a capital reserve requirement within the jurisdiction to be imposed on any stablecoin issuer who intends to offer products to domestic investors.
IV. New Proposal for Regulation on Stablecoins
A. Overall Considerations
To better support the policy set out by the Hong Kong government in 2022 to become a global leading hub for crypto-assets development, the HKMA issued the first discussion paper about the regulatory considerations and approaches soliciting public comments in early 2022. After a year of consultation, the HKMA published the conclusion of the discussion, which further refined the development policy and responded to concerns from investors and issuers.
The HKMA adopted a proactive regulatory approach and intends to form a relatively comprehensive regime before allowing any stablecoins to be offered to Hong Kong investors. Because the HKMA has considered the potential usage of stablecoins as a valid payment method, it has put a majority of the regulatory attention to the “payment-related stablecoins.” This does not mean that the HKMA would sit back and let other regulators handle non-payment-related stablecoins. It requires continuous cooperation between the HKMA and other regulators, including the SFC, to enhance investor protection against fraud and money laundering activities. As stablecoins are continuously evolving and might create new legal challenges, the HKMA proposed to adopt a flexible regime so that regulators could adapt to market developments and allow for the timely adoption of internationally agreed standards and practices where appropriate. An agile regulatory approach can be of benefit in addressing monetary and financial stability risks that may be posed by new stablecoin in a timely manner.
B. Key Elements of the Proposal
1. Regulated Stablecoins
The HKMA intends to adopt a risk-based approach in scoping stablecoin structures for regulation under the proposed regime. As a priority, the HKMA will start with regulating tokenized stablecoins, given the higher and more imminent monetary and financial stability risks posed by the currency-backed stablecoins. There are two reasons for the HKMA to put attention on the currency-backed stablecoins. Firstly, most of the stablecoins in circulation are currency-backed stablecoins and their major dominating assets are U.S. dollars. By taking the fiat-backed stablecoins into regulatory radar, the HKMA can handle a large proportion of the existing products. Secondly, the development of currency-backed stablecoins is more mature than other types of stablecoins. And investors are more readily to use currency-backed stablecoins as a valid payment method.
But new forms of stablecoins might emerge and quickly become a possible means of payment; therefore, the proposal suggested that appropriate flexibility shall be given to the regulator so that the authority can declare other types of stablecoins (other than tokenized stablecoins) to be subject to the regulatory regime in the future. To accommodate the flexible approach, the HKMA is thinking of providing guiding factors for enforcement agencies to consider.
2. Regulated Activities
As for the regulated activities, the HKMA follows suit and proposes to regulate a broad range of activities similar to other jurisdictions. Therefore, activities in a common stablecoins transaction model such as issuance, governance and management, transfer and remittance, custodial and safekeeping, risk management, information disclosure, and regular audits will be monitored by the HKMA. The stablecoin shares similarities with other mature payment methods in that different regulated activities can be taken by various entities. For example, the issuers of the stablecoins usually will also take charge of the functions of redemption and price stabilization. But the transfer of stablecoins or exchanges with other assets can be handled by centralized exchanges or between transacting parties without intermediaries. Therefore, all three functions might not necessarily be conducted by a single entity. The HKMA expected the possibility for multiple entities to be required to seek authorization in one type of stablecoin.
3. Licensing Regime for Stablecoin-related Activities
The HKMA is proposing to set up a licensing scheme for issuers and other related parties. With a licensing regime, the HKMA can effectively tackle the fund mismanagement issue (discussed in Section 3.2.3) by imposing adequate financial resources and liquidity requirements on potential applicants. To prevent a mixture of companies’ assets with clients’ funds, the HKMA can ask for clear and direct lines of responsibility and accountability, especially in the case of a group of companies located in various jurisdictions and taking charge of different roles. Additionally, the HKMA can utilize its abundant experience in licensing other financial institutions can apply similar requirements relating to the fitness and propriety of the controllers and senior management. Furthermore, to enhance the supervision, the HKMA intends to adopt a robust disclosure requirement, requiring the entity to provide reliable information such as its AML practices, financial status, safeguard measures for cyber-security, and operational risks.
In regard to the location of applicants, the HKMA is of the view that imposing a local incorporation requirement is highly conducive to enabling the regulator to effectively supervise the licensed entities and enforce the regulatory requirements, particularly for ensuring the company’s assets and liabilities will be appropriately segregated from the rest of the group and to facilitate seizure of assets where necessary for the purpose of user protection in case of failure of business.
Unlike the listing company requirement which allows overseas companies to be listed on the securities exchange by registering as non-Hong Kong companies, the HKMA minds not permit entities to simply open a Hong Kong branch to satisfy the local incorporation requirement. Instead, the requirement of incorporation in Hong Kong would offer more tools to the HKMA for effective regulation.
Finally, in order to create a positive environment for innovation, the HKMA allows non-bank institutions to issue stablecoins given that issuers can fulfill the licensing requirements. To uphold the principle of “same risk, same regulation,” the HKMA has to go through several rounds of risk assessment on bank and non-bank issuers before suitable licensing requirements can be formed. Likewise, the HKMA will measure entities based on activities and scale of the impact, and issuers bearing significant influence on the market can be designated as systemically important issuers with more stringent supervision.
C. Summary
The HKMA sees the need to ensure that payment-related stablecoins are appropriately regulated before they operate in Hong Kong or are marketed to the public of Hong Kong. The HKMA has recognized the importance of regulating stablecoin so that its responsibilities in maintaining the monetary and financial stability in Hong Kong can be properly conducted. Particularly, the collapse of major stablecoins issuers further proves that the HKMA has to place enough emphasis on issues that may affect the public’s confidence in the payment systems. By introducing a licensing regime, the HKMA can focus on the most widely used type of stablecoins. Because the licensing regime bears similarities with other arrangements that are currently under the HKMA’s supervision (such as banks and stored value facilities), the HKMA is more comfortable in applying regulatory tools.
V. Evaluation of Hong Kong’s Initiatives
A. The Licensing Regime Can Be an Effective Tool
From the discussion in the previous sections, regulators in various jurisdictions have different focuses such as AML concerns, influences on the existing monetary system, and potential positive usage by meaningful cooperation between regulators and issuers of stablecoins. “Notwithstanding variation in progress and approaches taken by different jurisdictions in regulating stablecoins, there is a convergence of the major aspects of their regulatory remit and requirements.” For example, there is a consensus to bring at least tokenized stablecoins, which can be widely used as a medium of exchange, into the regulatory perimeter. Regulatory efforts are moving towards the direction that a stablecoin should not rely on arbitrage activities to maintain a stable value at all times and should not derive its value from algorithms. The public response also supports the regulatory initiatives. According to the final conclusion paper of the consultation, practitioners generally welcome the risk-based and agile approach adopted by the HKMA, noting that a priority to stablecoins that have the potential to become a widely accepted means of payment is the appropriate direction for regulating stablecoins.
There is a common practice that regulators will set up a registration or licensing regime allowing for adequate information, monitoring, and prudential requirements. “It is essential to build systems to collect data on such instruments” and the licensing regime would be helpful in the information collection. Due to the global usage of stablecoins, regulatory cooperation remains a challenge and the lack of necessary information can be the first obstacle. Authorities can further establish an information-sharing arrangement in aid of cross-border enforcement against stablecoins. Building a data communication mechanism among regulators reduces potential financial stability risks.
But many regulators acknowledge that the development of stablecoins is still in an early and immature stage and precipitate legislation might not provide an effective framework encouraging healthy growth. The common dilemma in regulating financial innovation is more significant in the case of stablecoins given its large impact on the global scale. On the one hand, financial innovation cannot always fit into the existing framework and regulators tend to adopt a wait-and-see approach, only proposing a comprehensive regime after observation and lengthy consultations. On the other hand, leaving new products unregulated can create regulatory arbitrage. The principle of “same risk same regulation” calls for a more nuanced analysis in actual practice because the regulator might not fully grasp the underlying risks, then it would be impossible to choose an appropriate regulatory approach. Such dilemma is magnified in the global usage of stablecoins and it is a common phenomenon that the issuers place their corporation headquarters and custodian in one jurisdiction (often in a tax haven) and offer services to investors in other jurisdictions.
B. The HKMA Leans Towards Cautious Regulation
At the time of the responses, the Terra platform and FTX did not show signs of insolvency; therefore, the market and respondents did not expect the HKMA would adopt an even more conservative stance in regulating stablecoins. After the turbulent year 2022, one can easily notice that the HKMA further refined the regulatory scope and expanded it to include more types of entities in regulation. Under the refined regime, four types of entities need to obtain licenses before operation. Apart from stablecoins offered to Hong Kong investors, any stablecoins that are pegged with the Hong Kong dollar shall also be included in the regulation. The HKMA would hold any entity conducting a stablecoin-related activity in which the stablecoin concerned purports to reference its value to the Hong Kong dollar liable for obtaining a relevant license and be subject to the regulatory requirements, regardless of whether the relevant regulated activity is conducted in Hong Kong or actively marketed to the general public of Hong Kong.
Another important feature of the 2023 document is the enhancement of customer protection by imposing stricter requirements on issuers. To ensure the value of the stablecoins, the HKMA proposes a mandatory requirement for redemption at par value. The value of the reserve assets of a stablecoin arrangement should meet the value of the outstanding stablecoins in circulation at all times. There will be criteria for asset quality and liquidity. Stablecoins that derive their value based on arbitrage or algorithm will not be accepted. In the first stage of implementation, the HKMA might consider designating only certain types of assets with high quality and liquidity to serve as collateral. Furthermore, the HKMA raised a new requirement for the segregation of business and a regulated entity cannot conduct multiple businesses. This is a similar requirement for financial institutions currently subjected to the HKMA regulations. It can be argued that the HKMA uses the separation of business to isolate risk and prevent potential moral hazard.
C. Regulators Weigh the Late Mover Advantages
The government has issued an updated policy statement laying out the stance and approach towards developing a vibrant sector and ecosystem for virtual assets in Hong Kong by the end of 2022. But compared to other major economies that have already issued regulations on stablecoins, Hong Kong is not in the leading place. The prolonged consultation progress of the stablecoin regulation can be a powerful illustration. Though the HKMA originally only intended to have a three-month consultation in early 2022, the stablecoin market experienced much price volatility in May 2022 after the total failure of TerraUSD and received another severe damage to public confidence in November 2022 in the event of FTX bankruptcy. The HKMA underwent a more careful review and put more emphasis on financial stability risks; therefore, the conclusion of the discussion took longer time to be finalized with a more cautious attitude towards stablecoins.
While Hong Kong is not among those first-movers in proposing regulations on stablecoins, there are several important principles identified by the HKMA which is crucial for Hong Kong to make a robust regulatory regime. One of the most prominent strengths of the policy is to adopt a risk-based approach that is widely used and accepted for financial regulation and recommended by the Organization for Economic Co-operation and Development. The principle emphasizes on proportionality and requires assessing the levels of risk presented by stablecoins and providing appropriate measures to address them. “A risk-based approach involves prioritization of regulatory resources in the application of either detailed regulatory rules or more general principles, which can help Hong Kong regulators explore the more suitable regulatory framework for its policy and special development goals.”
Apart from the overall legislative process, Hong Kong regulators can utilize the later-mover advantages and learn more from jurisdictions that have already implemented regulations on stablecoins.
Firstly, for the legal clarity of stablecoins, it is important for the HKMA to make a comprehensive list of categories of stablecoins that are under supervision. The HKMA’s current regulatory focus is on tokenized stablecoins, therefore it might consider extending the definition of tokenized stablecoins to include stablecoins backed by collaterals with high quality and liquidity (such as US treasury bills and recognizable commodities). The HKMA can also consider the flexible definition approach adopted by the UK regulator, which delegates power to monitor and change the definition of stablecoins to enforcement agency. In such cases, the definition can effectively respond to changes in the features, underlying technology, or usage of these assets so that the regulation can continue to have effect.
Secondly, based on previous licensing practices in Hong Kong, it often took a lengthy consultation process before the regulator, industrial participants, and customers could reach a balanced outcome. Therefore, the timeline for the HKMA to promote a licensing regime for all stablecoins circulated in Hong Kong is rather tight. As discussed in previous sections, a robust licensing scheme offers regulators effective regulatory tools and the HKMA can consider utilizing technology in assistance of continuous monitoring. For example, the distributed ledger contains a lot of information relevant to supervisory purposes. Through a data-sharing requirement, the regulator can directly obtain information from the original records, which reduces the need for firms to actively collect, verify, and report data to authorities.
D. The Regulatory Scope Calls for Further Clarification
It can be seen from the public responses that even practitioners of the crypto-asset industry have certain confusion over the definition and regulatory scope. Therefore, it would be more difficult for retail investors and other vulnerable sectors of Hong Kong society to understand the exact regulated activities and products, which might impede investor education and protection.
According to the public responses, respondents have some confusion as some commenters cannot differentiate between “payment-related stablecoins” and “non-payment-related stablecoins,” and ask for clearer guidance for judging the scale of usage. Compared to confusion about regulatory scope, the difficulty in understanding the differences between the existing regime and the proposed framework seems to be a more significant challenge for the public. On the one hand, some practitioners noted a degree of similarity between the new framework and regime for banks, which sets up a high standard and focuses on financial stability, thereby questioning the necessity to hold stablecoins at the same regulatory level as banking institutions. On the other hand, the public confused the new regime with the framework supervised by the SFC concerning the operation of crypto-assets trading platforms or the scheme overseen by the HKMA regarding SVFs. It will remain a challenge for the HKMA to work with other regulators to minimize regulatory arbitrage and overlaps and offer sufficient education to the public.
VI. Suggestions for Future Development
A. Finalize the Development Path
Given that the HKMA has already developed a framework for stored value facilities (SVFs), there are concerns that regulations on stablecoins might overlap with the existing framework, causing either a waste of supervisory resources or loopholes. Under the existing framework, if a stablecoin can be utilized for storing the value of an amount of money and used as a means of making payments for goods or services, the HKMA might conclude that the stablecoin constitutes an SVF and is subject to the current licensing regime. As discussed in Section 3.2.1, stablecoins can easily modify their features to evade regulations on SVFs. Therefore, the HKMA should be mindful to consider expanding the scope of the existing framework on SVFs or introducing new legislation with a focus on payment-related stablecoins.
Balancing the interests of different stakeholders is another important factor for determining the development path. Some respondents come from the crypto industry and find that the HKMA’s proposal for full-scale regulation is burdensome. It is reasonable to expect that industry practitioners would expect less restriction and regulation. But their comments also offer insights for policy formulation. For example, one respondent commented that the HKMA shall only focus on information disclosure instead of regulating other activities such as issuance and redemption. The commentator emphasizes the openness of the blockchain and how all transactions can be observed by all users through on-chain analytics. At the same time, the information disclosure cannot replace the necessary independent audit, so the commentator also suggested enhancing the fund management and third-party audit. Another respondent also recommended the HKMA focus on a limited number of activities instead of including a long list of activities such as transfer of funds, validation of records, as well as executing transactions in stablecoins on behalf of others.
It is also reasonable that respondents with accounting and regulation backgrounds call for a more tightened scheme. Some are dissatisfied with the scope of regulated activities, citing that secondary or ancillary activities (such as entities storing private keys or operating exchanges) shall also be included in the regulations. Furthermore, professionals provide detailed suggestions on managing customers’ funds including no pledge of the reserve assets or using the reserve assets to fulfill obligations of the issuer.
B. Refine Framework from International Experiences
According to the overall development policy on crypto-assets issued by the Hong Kong government at the end of 2022, the HKMA shall continue its ongoing discussion with other financial regulators and learn more from international experiences. The HKMA needs to enhance financial innovations and encourage institutions to explore the potential of distributed ledger technology to support the responsible development of the crypto-asset ecosystem in Hong Kong. At the same time, the risk-based approach, as well as the principle of “same activity, same regulation” and applicable international standards can be a useful guidance in formulating detailed regulations. Specifically, because the regulatory framework has not been finalized, the HKMA still has a chance to observe market developments and the risks that different categories of crypto-asset may pose to monetary and financial stability and then transfer experiences (both success and failure cases) into a more nuanced regime.
Any regulatory efforts should also be collaborative and include all stakeholders and should not hinder innovation and entrepreneurship or impair competition. Most importantly, regulators should not view stablecoins through the narrow lens of underlying blockchain technology but should remain technology-neutral in their approach. In fulfilling their regulatory objectives, regulators need to be mindful of the opportunities that stablecoins bring to the financial sector but also to the regulators themselves. The principle of “same activity, same regulation” should not translate into blind application of the legacy rules to new technological advancements. A long-term regulatory vision should consider grasping the opportunities and embracing the competition and diversity of the ecosystem.
Although the proprietary right of stablecoins is not the primary focus of regulators in the financial market, the legal nature, which was left unaddressed by most jurisdictions, could influence the interest of investors and counterparties. Hong Kong regulators could start to explore the legal nature of regulated stablecoins which is important for stakeholders to determine their rights and interests. Global organizations, such as the G-7 Working Group, noticed this issue and commented that in some jurisdictions, stablecoins may constitute financial instruments—such as a debt instrument or representation of interests in a fund—and be subject to applicable laws relating to securities and financial instruments. Because proprietary rights and contract rights could entail different legal treatments, confusion about the legal nature can lead to different tax treatments, criminal sanctions, or available civil remedies to grieved parties.
C. Design Appropriate Sanctions
It is a common practice for Hong Kong regulators to impose administrative and criminal penalties for non-compliance. Because the HKMA intends to adopt a licensing regime for regulating stablecoins, it is foreseeable that the HKMA will adopt a similar sanction arrangement currently applied to other financial products. Though sanction is used as an efficient means to deter market impropriety, different features inevitably lead to nuanced differences in designing penalty systems. As for stablecoins, the HKMA shall keep a proper balance in punishing licensed entities. On the one hand, stablecoins are expected to be used as a payment method and can have a significant impact on the financial system. Accordingly, the HKMA shall hold a higher bar for granting licenses and put more severe penalties to deter possible systemic risks. On the other hand, different entities can play various functions regarding the same stablecoin and sanction shall be commensurate with the damages caused by respective parties.
D. Coordinate with Domestic and Global Agencies
It shall be noted that the activities to be regulated under the proposed stablecoins regime might overlap and interface with other financial regulatory regimes in Hong Kong, such as the licensing regime for virtual asset service providers that are supervised by the SFC. The sector-based regulatory arrangement might create obstacles to departmental cooperation. It will be a continuous task for the HKMA to conduct assessments and “work with other regulators as well as relevant stakeholders when formulating the details of the regime in order to avoid regulatory arbitrage, identify and address regulatory overlaps or gaps, and mitigate the risks arising from different activities.” The coordination mechanism used by the UK regulator can offer a possible solution to improve the lack of cooperation between different enforcement agencies. The Hong Kong government might consider mandating a regulatory body (such as the Financial Services and the Treasury Bureau) to coordinate the cooperation between the HKMA and the SFC so that overlap or mismanagement can be minimized.
Regulators around the world would agree that the usage of stablecoins for cross-border payment is increasing and the global circulation of stablecoins can create an efficient and reliable alternative for money transfer. Current user cases show that with the maturity of technology, stablecoins might become a commonly used payment method in the global market and fit the definition of “global stablecoin (GSC)” proposed by the Financial Stability Board (FSB). The potential adoption across multiple jurisdictions distinguishes a GSC from other stablecoins because a GCS can create additional risk to financial stability. By analyzing the history of several prominent stablecoins, one can find out that a stablecoin can rapidly expand its customers and possess the potential to become a GSC. Therefore, Hong Kong regulators shall allocate adequate resources and provide the necessary legal power to apply comprehensive and effective regulatory requirements. As the regulatory standard proposed by the FSC can be modified in accordance with the rapid changes in GSC development, Hong Kong shall pay close attention to international reform and timely adjust the existing framework.
One key component for regulating GSCs is cross-border cooperation, and Hong Kong regulators shall foster an effective coordination working method for information sharing and enforcement. It would not be an easy task to form a comprehensive cooperation framework with an unfamiliar jurisdiction with which Hong Kong regulators have never worked before. Given the novelty of stablecoins, Hong Kong can first consider focusing on several specific areas that bear similarities with other financial products, such as anti-money laundering, so that both parties will be more comfortable and readily able to take effective actions.
VII. Conclusion
As regulation on crypto-assets has to always try to match the latest development of the regulated market, it is a necessary process for Hong Kong regulators to take careful deliberation before promoting a regime in a highly dynamic industry full of uncertainty. This article has analyzed the existing regulatory stance of the HKMA and tried to identify the major considerations and potential development directions for academia and industry. There are several prominent features of the regulatory approach adopted by the HKMA and related suggestions are provided.
First of all, balancing the different interests of stakeholders and encouraging healthy growth of the crypto-assets industry is never an empty slogan for marketing, as practitioners vote by their feet and relocate businesses to more favorable environments. But the market turbulence urged the HKMA to take a more cautious stance, raising entry requirements by including non-Hong Kong-based entities issuing HKD-pegged stablecoins into regulation and imposing mandatory redemption at par value. As the legislative bill is still under discussion, it calls for close observation of the finalized draft.
Secondly, the HKMA is facing the challenge of integrating the proposed regime into the existing framework. A general observation from the public pointed out that both ordinary retail investors and professional practitioners are confused, worrying about possible overlap and waste of regulatory resources. This issue has been further complicated by the sector-based regulatory arrangement in Hong Kong, and the HKMA shall make the coordination with other agencies more transparent, which is of benefit for investor protection.
The HKMA has referred to the guidance of the Financial Stability Board (FSB), which intends to conduct a review of the implementation of the proposed recommendations by end-2025. If the HKMA wants to catch up with the timeline laid by the FSB, then the consultation shall be conducted in a timely manner and Hong Kong has to firmly promote a concrete legislative framework and transfer the policy consideration into regulation.
