Key Points and Challenges for Hong Kong Stablecoin Issuer License Applications

Authors: Xun LI丨Felix MIAO丨Bo ZHENG丨Song HONG

Startup for stablecoins licenses: 60-day countdown begins

With the effectiveness of the Stablecoins Ordinance in Hong Kong on August 1, the application process for stablecoins issuer licenses under the Stablecoins Ordinance has officially opened.  All the time points for application have been confirmed, and the application process has entered the 60-day countdown (please refer to the following chart for details of the application process and key time points).

On July 29, the Hong Kong Monetary Authority ("HKMA") issued the following six documents in relation to the Stablecoins Ordinance in order to clarify the specific regulatory requirements and assist relevant market players to fully understand the application requirements:

1.   Explanatory Note on Licensing of Stablecoin Issuers (the "Explanatory Note on Licensing")

2.   Explanatory Note on Transitional Provisions for Pre-existing Stablecoin Issuers

3.   Guideline on Supervision of Licensed Stablecoin Issuers ("Guideline for Issuers")

4.   Guideline on Anti-Money Laundering and Counter-Financing of Terrorism (For Licensed Stablecoin Issuers) ("Guideline on Anti-Money")

5.   Consultation Conclusions on Draft Guideline on Supervision of Licensed Stablecoin Issuers

6.   Consultation Conclusions on Proposed AML/CFT Requirements for Regulated Stablecoin Activities

We have previously analyzed the content and impact of the Stablecoins Regulations (see our previous article which provides further guidance to clients who intend to lodge formal applications prior to the application deadline in relation to the application of the Stablecoins Regulations, based on the above documents and our understanding of the current practice in respect of applications for stablecoin licenses).  This article provides further guidance to potential stablecoin license applicants who intend to submit formal applications prior to the application deadline ("Applicants") based on the above documents and our understanding of the current application practice.

Key points for stablecoin license applications

According to the provisions of the Stablecoins Ordinance and the Explanatory Note on Licensing, currently the HKMA has several minimum standards for license applicants, and applicants are required to prove that they can continue to satisfy the relevant requirements after being granted a license, which can be regarded as pre-conditions that Applicants must satisfy.  The following contents only list some of the key requirements for Applicants and do not represent the complete set of minimum criteria that HKMA has set out.

I.   Legal person status

According to the Stablecoins Ordinance, only two types of entities are allowed to apply for Stablecoin licenses: (1) companies incorporated in Hong Kong; and (2) authorized institutions incorporated outside Hong Kong.  In particular, the approved institutions are limited to three types of entities, namely, banks, companies with restricted licenses, and companies that take deposits as prescribed in the Banking Ordinance of Hong Kong.

Therefore, an Applicant that is located outside Hong Kong and is not the aforesaid banking financial institution, it must appoint a subsidiary it has established in Hong Kong to apply for a stablecoin license.  Banking financial institution located outside Hong Kong may apply for a stablecoin license directly without the need for a subsidiary in Hong Kong.

II.   Financial resources

According to the Stablecoins Ordinance, an Applicant must have sufficient financial resources and liquid assets to perform its redemption obligations corresponding to the issued stablecoins.  Currently, the minimum paid-in capital as prescribed in the Ordinance is HK $25 million or equivalent amount in other currencies, but the Monetary Authority has the power to require an Applicant to provide a higher amount.

Considering the demonstrative effect of the first batch of stablecoin licenses, and HKMA's preference for the maturity of redemption of stablecoins and the overcollateralization of reserve assets, an Applicant may fully explain its own or its parent company's capital strength to prove that it can inject more capital according to business or regulatory needs through share capital increase or otherwise, so as to support its stablecoins business.

III.   Reserve asset management

According to the Stablecoins Ordinance, an Applicant shall adopt a reserve portfolio consistent with the stablecoins to be issued and have a licensed Hong Kong bank act as the custodian for the portfolio.  The reserve assets shall be high-quality and highly liquid financial assets with minimum investment risk.  The Monetary Authority may only, with prior written approval, permit an applicant to adopt a reserve portfolio with a currency mismatch (for example, using U.S. dollar-denominated assets as the reserve assets to be issued in the Hong Kong dollar stablecoins) in exceptional circumstances.

According to the Guideline for Issuers, the current reserve assets of stablecoins issuers have made it clear to include investment funds specially established for stablecoins issuers, and the reserve asset portfolios of stablecoins issuers may be formed by investing investment funds in cash, short-term bank deposits, short-term high-credit bonds and cash receivables generated from overnight reverse repurchase agreements.  In other words, 9 fund management companies registered by the SFC may assist the currency stabilizing issuers in managing the reserve portfolio in the form of investment funds, which will help the currency stabilizing issuers to carry out subscription, redemption, regular disclosure and other operations for the reserve portfolio, improve the transparency of the reserve portfolio, and provide a solid guarantee for the management of the reserve assets.

Therefore, if an Applicant chooses to apply for a stablecoin license jointly with a Hong Kong licensed fund company (acting as reserve asset trustee) and a Hong Kong licensed bank (acting as reserve asset custodian) which has extensive experience in investment fund management, it will be beneficial to fully demonstrate the synergies of the consortium in operating stablecoins business and win the trust of HKMA.

IV.   Issuance, redemption, and distribution

According to the Stablecoins Ordinance, an issuer of stablecoins may only issue stablecoins to its clients at the issuance stage, and pursuant to the Guideline on Anti-Money, clients holding stablecoins shall comply with the relatively strict anti-money laundering requirements; in the redemption stage, an issuer of stablecoins shall dispose of the redemption demand within one business day; and in the distribution stage, an issuer of stablecoins shall take into full account the regulatory rules of the distribution jurisdiction, and shall not distribute stablecoins issued by a licensed party in any jurisdiction where stablecoins trading is prohibited.

Therefore, the applicant may focus on its experience in anti-money laundering and the distribution channels and partners for the sale of financial products in various countries/regions to prove its strength in the issuance, redemption, and distribution of stablecoins.

V.   Suitable candidates

According to the Stablecoins Ordinance, the persons acting as chief executive officer, director, manager or controller of the applicant must be the proper persons with the relevant knowledge and experience and shall have the consent of the Monetary Authority.  In addition, the senior management and key personnel of the applicant must be located in Hong Kong.  However, given that banking financial institutions located outside of Hong Kong are permitted to apply for the license under the Stablecoins Ordinance, we understand that there may still be room for interpretation regarding this provision.

In light of the limited number of potential candidates with experience in stablecoins who may be acceptable to HKMA, and the fact that some of the offers for appointment may have already been received, it is important for an applicant to confirm and contact its candidates for the relevant positions as soon as possible, and communicate with HKMA about the candidates at the pre-communication stage.

VI.   Risk management

According to the Stablecoins Ordinance, an Applicant is required to have sound and appropriate risk management policies and procedures in place, covering the dimensions of credit risk, liquidity risk, market risk, technological risk, operational risk, reputation risk, etc., and adopt anti-money laundering measures to manage and control AML/CFT risks.  In particular, as emphasized by HKMA CEO David Yu, in terms of anti-money laundering and anti-terrorism financing regulatory standards, stablecoin licenses will be almost the same as those of banks and electronic wallets, so it is self-evident that such risk management provides a high barrier to entry.

Given that HKMA has repeatedly expressed its preference for the Basel Accord financial regulatory standards, applicants with a banking financial institution background and are familiar with risk management requirements in the banking industry may be favored by HKMA.

Difficulties encountered in applying for stablecoin licenses

In the past few months, the topic of stablecoins has aroused a series of discussions, and the announcement of stablecoin license applications or stablecoin concepts by a number of listed companies has created hype, which has led to the financial supervision authorities in the Mainland and Hong Kong to repeatedly release documents to alert the public to the risk of illegal fundraising and fraud related to stablecoins.

In addition, relevant Hong Kong officials repeatedly expressed HKMA's prudent attitude towards the applications for stablecoin licenses through its official website and news interviews, which helped to cool down the trend towards stablecoins.  For example, HKMA CEO David Yu, recently released a statement, clearly expressing the HKMA's regulatory position on stablecoin licenses, which will be "stricter before looser".  According to a public news report, the number of applicants eligible for the first batch of stablecoin licenses may be reduced to three or four.

Applicants intending to apply for the first batch of stablecoin licenses will need to overcome the following difficulties from an application perspective:

I.   Formulate a stablecoin issuance plan in advance

In view of the entry requirements and application costs for stablecoin licenses, HKMA broke common practice and set the period from August 1 to August 31 as the pre-communication period for stablecoin licenses to compel any potential applicant to contact HKMA and communicate about license application matters.

Although HKMA has clarified that "pre-communication is not a selection process", given the difficulty in obtaining the first batch of stablecoin licenses, and HKMA's resistance to applicants who fail to provide detailed, practical and feasible proposals and implementation plans, having a comprehensive stablecoin issuance plan is of great significance to the communication efforts of the applicants at the pre-communication stage, which will help HKMA to better understand the purpose of the issuance and the stability level of the applicants.  In terms of the specific content of the issuance plan, in addition to the demonstration by reference to the regulatory requirements of the Stablecoins Ordinance, the demonstration of the applicant's corporate strategy that intends to invest the stablecoins business for a long time and continuously can also be used as an important basis for the subsequent drafting and publication of a white paper on stablecoins.

II.   Fully demonstrate the stablecoin application scenarios

HKMA CEO David Yu has stressed in public many times that stablecoin issuers need to have sufficient support, key capabilities and experience in different areas, such as reserve asset management and asset security systems, effective price stabilization mechanisms, comprehensive and feasible redemption policies, as well as capabilities in science and technology security, risk control and anti-money laundering, etc.  The most critical aspect is that issuers must fully explain the application scenarios of the stablecoins to be issued, and the ability and determination to continue operations in various market environments.

According to an analysis conducted by research institutes, about 95% of the stablecoins currently in circulation and trading are used in crypto asset trading, and only 5% are used in cross-border trade payment and settlement.  In other words, the current application scenarios for stablecoins remain relatively limited beyond cryptocurrency trading, indicating significant room for growth.  Considering the wide gap between the real-name system requirements put forward in the Guideline on Anti-Money and the current situation of generally anonymous transactions in the stable coin industry, if an applicant has a comprehensive business ecosystem and needs for payment and settlement, it may support the real-name circulation of stable coins in the ecosystem at the early stage of business development.  This will help the HKMA in exploring the future application scenarios of stablecoins and will also be a very advantageous additional point for the application.

III.   Actively seek support from local regulatory authorities

Unlike the locality-bound nature of other financial licenses, blockchain addresses that hold stablecoins can transcend national borders with relative ease, as stablecoins are inherently decentralized.  Therefore, the Explanatory Note on Licensing specially emphasizes that an Applicant must consult with the relevant regulatory authorities at the place where its head office is located before submitting an application, and consider whether the Applicant has any areas that need attention when developing the stablecoins business.

Although these requirements do not explicitly require the applicant to obtain the express consent of the local regulator as a precondition, given that the cryptocurrency that the stablecoins belongs to is subject to strict restrictions in many countries/regions, such opinion will undoubtedly play a significant role in the outcome of communication.  Therefore, an applicant who can obtain the express support or even endorsement of the local regulator will significantly enhance the recognition of the applicant by HKMA and accelerate the progress of the application for licenses.

Conclusion

When the frenzy for stablecoins in the market gradually calms down, we predict that the number of finalists in this competition will fall short of market expectations.  The attitude of the HKMA undoubtedly indicates that the issuers of stablecoins, as an on-chain financial infrastructure, is destined to be subject to the strictest financial regulatory scrutiny together with the off-chain commercial banks and payment institutions.

We believe that, rather than driving a race to the issue of homogenous stablecoins, HKMA hopes to use stablecoins as a medium of exchange to practice the regulatory vision of supporting the development of tokenized products as set out in the Hong Kong Digital Asset Development Policy Statement 2.0, to provide incentives for the tokenization of real-world assets and financial assets, and to promote the compliant development and prosperity of on-chain finance.