Seventeen Questions on the Regulation of Stablecoin Issuers in Hong Kong

Mobile Payment Network News: The Hong Kong Monetary Authority (HKMA) recently officially released the "Guidelines for the Supervision of Licensed Stablecoin Issuers" (the "Guidelines"). As one of the core supporting documents for the Stablecoin Ordinance, the Guidelines aim to regulate the operations of stablecoin issuers, prevent financial risks, and safeguard investor rights and the stability of the financial system. The HKMA previously published a draft of the Guidelines and solicited industry feedback, receiving 28 responses. After summarizing the comments, the HKMA reached a consultation conclusion on the Guidelines. The consultation conclusions provide a glimpse into the industry's main concerns and the HKMA's responses. Does the full reserve requirement apply only to the local reserve asset pool or to the global reserve asset pool?

The Hong Kong Monetary Authority has clarified that, regardless of whether a single-jurisdiction issuance arrangement or a multi-jurisdiction issuance arrangement is adopted, licensed institutions must ensure that designated stablecoins as a whole are fully funded, including those that have been frozen or blacklisted.

Can tokens of eligible assets be considered reserve assets?

The Hong Kong Monetary Authority adopts a technology-neutral attitude in this regard, stating that it can accept tokens of eligible assets as part of reserve assets.

However, the prerequisite is that the licensed institution can demonstrate to the HKMA that these assets comply with the relevant requirements of the Guidelines and do not have any unresolved risks, including potential technical or operational risks.

Is currency mismatch allowed?

If such currency mismatch is required, the licensed institution should provide reasonable justification and obtain prior approval from the HKMA. In other words, the HKMA may conditionally allow currency mismatch in some cases.

Licensed institutions must demonstrate their ability to maintain full repayment at all times, including under extreme and market stress conditions, while ensuring that any currency mismatch measures will not transfer risks to stablecoin holders.

In addition, licensed institutions must discuss and obtain approval from the Hong Kong Monetary Authority before proposing plans such as the composition and proportion arrangements of reserve assets and risk management measures.

Regarding the segregation and custody of reserve assets, is it feasible to store reserve assets outside Hong Kong?

Hong Kong licensed banks or other institutions approved by the Hong Kong Monetary Authority will be appointed as custodians of stablecoin reserve assets.

In fact, the Hong Kong Monetary Authority does not explicitly prohibit licensed institutions from storing part of their reserve assets outside of Hong Kong, but licensed institutions must fully explain the reasons and the basis for selecting the appropriate custodian.

At the same time, licensed institutions must also demonstrate that these reserve assets stored outside of Hong Kong are properly safeguarded and ensure that stablecoin holders can withdraw these reserve assets in a timely manner when they request redemption.

Can the management of stablecoin reserve assets be entrusted to investment managers?

The Hong Kong Monetary Authority believes that licensed institutions may employ investment managers, but they must ensure that the investment managers have the relevant qualifications and that the level of protection for stablecoin holders is not affected.

What is a "valid redemption request"?

Some market institutions believe that the account opening procedure may take a certain amount of time, which makes it more difficult to "process redemption requests within one business day."

The Hong Kong Monetary Authority explained that if the preconditions are not met (such as the necessary account opening procedures), the additional time required should not be counted towards the "processing redemption within one business day" requirement.

In addition, any unresolved potential compliance issues (such as unresolved money laundering issues) may be regarded as a failure to meet the preconditions, thereby rendering the redemption request invalid.

Of course, the HKMA also added that licensees should ensure that the redemption conditions and time limits they set are reasonable.

Is it allowed to employ distributors outside Hong Kong?

The HKMA does not prohibit licensed institutions from employing distributors outside Hong Kong. However, licensed institutions should conduct due diligence and risk assessments before engaging a third party, and conduct ongoing monitoring throughout the entire process, while also adhering to relevant third-party risk management measures. Furthermore, licensed institutions should pay particular attention to compliance with local laws and regulations. Is it necessary to engage a third party to provide liquidity in the secondary market? The Hong Kong Monetary Authority (HKMA) believes that stablecoin issuers typically engage market makers to provide secondary market liquidity for their stablecoins, and this is a common practice. The HKMA stated that this arrangement carries risks and could undermine the confidence of stablecoin holders in the stablecoin. For example, market makers may intentionally create a "decoupling" phenomenon in the secondary market or create other conflicts of interest. The Guidelines require that the issuance of designated stablecoins must be prudent and robust, and that the hiring of market makers should properly manage related risks and potential conflicts of interest. This can be done, for example, through specific contracts that specify the responsibilities of the market makers. Collaboration with market makers is not mandatory. Licensed institutions should consider whether such cooperation is necessary based on the purpose, business model, and operational arrangements of issuing a specific stablecoin. Should VPN use be completely banned?

Some believe that users may use VPNs for privacy purposes and suggest that some risk management measures can be taken rather than a complete ban.

In response, the Hong Kong Monetary Authority believes that licensed institutions should develop a set of effective measures to ensure which groups are prohibited from accessing their services, and identifying VPNs and subsequent activities should be part of such measures.

Should quantitative requirements be set for over-collateralization?

In terms of market risk management, some suggest that the Hong Kong Monetary Authority could set quantitative requirements for over-collateralization. The Hong Kong Monetary Authority responded that the scope and composition of reserve assets of different licensed institutions vary, and adopting an appropriate proportion approach is more conducive to addressing risks and minimizing unnecessary regulatory burdens. Clearly, the Hong Kong Monetary Authority has no intention of setting specific requirements for over-collateralization in the Guidelines at this stage, but has also stated that it will consider whether to provide relevant guidance later, depending on the circumstances. For example, the required over-collateralization level could be arranged based on factors such as the nature and maturity of each type of asset. Will stronger token risk management techniques be adopted? In terms of technical risk management, some suggest adopting tiered minting (setting different levels of authorization for minting of different scales) and pre-minting (pre-minting designated stablecoins into operational wallets and then transferring them to customers upon request) to enhance the security of token management. The Hong Kong Monetary Authority has stated that it has no intention of stipulating or arranging specific technical requirements for issuing stablecoins. However, the Guidelines set out relevant requirements and encourage the adoption of a tiered management security approach. For example, if pre-minting is adopted, pre-minted stablecoins should, in principle, be fully backed by reserves to prevent the release of unbacked stablecoins into the market due to wallet compromise.

Can cloud-based hardware security modules (HSMs) and private key management be outsourced to third parties?

The Hong Kong Monetary Authority pointed out that private key management is one of the important core businesses that affect the prudence and soundness of licensed institutions. Therefore, although the Hong Kong Monetary Authority does not prohibit the outsourcing of certain technical arrangements or private key management businesses, it will adopt a cautious and strict attitude when assessing the relevant risks.

Will the localization requirement for private key management be cancelled? The Hong Kong Monetary Authority emphasizes that the private key management systems implemented by licensed institutions must be robust and secure, and localization requirements ensure that regulatory work can be carried out effectively. Of course, the Hong Kong Monetary Authority also provides flexibility for licensed institutions to store and use private keys outside of Hong Kong, but will adopt a cautious and rigorous approach when evaluating relevant arrangements. What are the qualifications required for third-party smart contract audits? The industry has not yet established relevant standards for smart contract audits or clearly defined the required qualifications. Therefore, the Hong Kong Monetary Authority expects licensed institutions to consider factors such as professional capabilities, performance, and reputation when assessing the qualifications of third-party auditors and to explain these to the regulator.

Are smart contract audits required for all code changes, or only for major upgrades?

Given the importance of smart contracts to the prudence and robustness of licensed institutions' operations, the Hong Kong Monetary Authority believes that smart contract audits should be conducted for all code changes. Because smart contract code changes are infrequent, this requirement will not place a significant burden on licensed institutions.

Can Hong Kong regulators explore mutual recognition mechanisms with regulators in other regions?

The Hong Kong Monetary Authority pointed out that the feasibility of mutual recognition arrangements depends on many factors, including the development of regulatory frameworks in other jurisdictions and international consensus. It will continue to pay attention to international developments and is willing to explore the possibility of mutual recognition in the future.

Of course, any mutual recognition arrangement cannot replace the issuer's obligation to fulfill regulatory requirements in Hong Kong.

Will special regulatory measures be implemented for systemically important stablecoins? There are currently no arrangements, but the Hong Kong Monetary Authority stated that the international regulatory environment is constantly evolving and will consider whether additional regulatory requirements are needed based on the international regulatory status of systemically important stablecoins.