Hong Kong has long been an innovator when it comes to moving value at speed: from providing the launchpad for the world’s most used smart card system (Octopus) to implementing one of the earliest regulatory structures for virtual banking globally in 2000 (further enhanced in 2018 as part of a package of smart banking initiatives).[1] Hong Kong also has a longstanding digital equivalence law[2] – critical to digital transactions.

The landscape for “value” continues to change at pace. This demands a dynamic regulatory response and Hong Kong, true to form, is moving.

The inevitable changes to financial infrastructure in turn demand a response from businesses: including planning technology upgrades early, engaging in policy development and identifying opportunities.

Enhanced cross-boundary and cross-border connectivity

As the legal framework has grown, so too have practical initiatives to help move value between Hong Kong and Mainland China and other jurisdictions. This spans the launch of the first multi-currency cross-border payment arrangements in 2009, through to multiple “Connect” programs that require FX and currency settlement transactions to enable the purchase of funds, bonds and most recently, wealth management products via designated mechanisms. These carry significant legal and technical complexity. Our synopsis of the Greater Bay Area “Wealth Management Connect” scheme is available here.

Recent efforts with other markets heavily focus on trade finance, including building connectivity to Hong Kong’s distributed ledger technology (DLT) based eTradeConnect and leveraging the growing book of memoranda of understanding that Hong Kong regulators have formed with their counterparts in relation to fintech and broader ecosystem development. Experimentation features heavily – proofs of concept test both ideas and technologies.

A seismic shift - stablecoins, CBDCs and more

Against this backdrop, the past 12-24 months have seen an acceleration of initiatives that demonstrate how swiftly the nature of value and its transmission have changed. Fiat currency is no longer the only way that value moves, with the advent of virtual assets.

The burgeoning digital economy demands technically advanced representations of fiat, with a flourishing panoply of “stablecoins” that seek to trade at parity with particular fiat currencies (eg USD) to help enable smart-contract based transactions and access to virtual asset markets. The launch of Mainland China’s digital renminbi (e-CNY) has also cast new light on Hong Kong’s longstanding “Project Lionrock” investigating the potential launch of a digital Hong Kong Dollar.

All of a sudden, money and payments don’t quite look the same anymore.

Like many other jurisdictions, Hong Kong has largely taken a “wait and see” approach to virtual asset regulation, although regulators issued clarificatory circulars as far back as 2014 and the SFC implemented a form of “opt in” regime in 2018.

However, the growth of the sector has forced Hong Kong to move toward a far more comprehensive model. Hong Kong also has important international commitments. For example:

  • Financial Action Task Force (FATF): as a member of the global standard setter on anti-money laundering and counter-terrorist financing, Hong Kong seeks to implement the FATF Recommendations, which expanded to cover virtual assets in 2019.

More recent updates in 2021 broke further ground in signalling emerging focus areas that will inevitably more fully regulate “metaverse” and Web 3.0 (decentralised) platforms.

  • International Organization of Securities Commissions (IOSCO): Hong Kong’s regulators also participate in critical fora such as IOSCO, which has turned its attention to stablecoins.[3]

Key developments to meet this challenge include:

  • Virtual assets – building a comprehensive framework for a licensing regime

In late 2020, the Financial Services and the Treasury Bureau (FSTB) launched a public consultation (VASP Proposal) to amend the AMLO. The view was to regulate certain virtual asset exchanges that trade previously non-regulated virtual assets, by introducing a mandatory licensing regime. In May 2021, the FSTB published the VASP Proposal conclusions, without material change. A legislative bill (Bill) was gazetted on 24 June. See our detailed alert on the Bill here.

More recently, the SFC and other regulators have issued guidance for their existing regulated entities on their engagement in the virtual asset sector. This provides much needed certainty for the industry as a whole.

  • Stablecoins

The VASP Proposal does not directly deal with the primary issuance of virtual assets or their inherent virtual asset structure or governance. However, stablecoins (a type of virtual asset) have attracted a much closer degree of attention.

What is a stablecoin and how are they structured?

In January 2022, HKMA issued an exploratory “Discussion Paper on Crypto-assets and Stablecoins”. The Discussion Paper summarises a number of key industry, transnational and global regulatory developments relating to stablecoins. It goes on to describe its policy questions and initial views. Industry feedback ended on 31 March 2022.

Key aspects of the HKMA’s initial views include:

  • a focus on asset-linked stablecoins and not algorithm-based stablecoins for the initial phase of regulation. There are good arguments to include both in scope now, but there are equally very real challenges of doing so effectively when many involve decentralised aspects which can be difficult to regulate
  • capturing a very broad range of activities within the PSSVFO or other legislation, including minting and burning stablecoins, managing reserve assets, validating transactions and records, storing private keys, facilitating redemption, transmitting settlement funds and executing transactions, and
  • a robust regulatory architecture including authorisation requirements, prudential standards, “fit and proper” requirements, reserve requirements, AML/CTF controls and a range of other systems, controls, governance, risk management, reporting, security, settlement finality and other requirements.

Many of the proposals mirror the existing stored value facilities regime. This makes sense, as asset-backed stablecoins are arguably just another digital representation of value. They also require many of the same controls. However, it will be important to navigate crucial nuances and the fact that so many different legal structures can be adopted for stablecoins, so the risk of regulatory overlap and regulatory arbitrage are both high. The ability of the regime to address algorithm-based stablecoins in due course will also be important.

  • Central bank digital currencies (CBDCs)

Hong Kong has been investigating a potential model for CBDCs since 2017 as part of “Project Lionrock”. Hong Kong has also been collaborating with other markets for some time to consider how CBDC interoperability might help solve cross-border transaction pain points.

The past 12 months has seen two key developments in relation to CBDCs in Hong Kong:

• e-HKD: technical whitepaper on a Hong Kong CBDC

In July 2021, the HKMA issued a technical whitepaper on the potential issuance of a Hong Kong CBDC, in collaboration with the Bank for International Settlements International Hub Hong Kong Centre (BISIHK).

The proposed architecture issued for comment includes a two-tier model, a wholesale system involving the central bank, and a retail system enabling commercial banks to circulate e-HKD or e-HKD backed e-money.

Key areas for comment covered privacy, interoperability, performance and scalability and cybersecurity, compliance, operational robustness and resilience, and technology-enabled functional capabilities.

In April 2022 the HKMA published a discussion paper addressing potential benefits and challenges brought by retail CBDC, various design considerations (including issuance mechanism and legal considerations) as well as use cases of e-HKD.

The discussion paper invited public feedback on a wide range of policy issues on the feasibility of e-HKD. These include possible use cases which can be better implemented by e-HKD than the existing e-Payment options, design features which facilitate future digital economy and innovation, and interoperability of e-HKD with the current payment systems.

• mBridge: connecting markets

The HKMA is collaborating with BISIHK, the Bank of Thailand, the Digital Currency Institute of PBOC and the Central Bank of the United Arab Emirates in relation to “mBridge”. This is a wholesale-only central bank CBDC project involving the potential creation of a DLT platform that serves as a bridge between these markets to facilitate cross-border FX transactions and payments at an institutional level.

What does this all mean?

Financial infrastructure is changing in fundamental ways.

The key points to consider are:

  • Should we be experimenting? There are multiple proofs of concept underway in both regulator-led projects as well as by individual banks and other institutions. Testing ideas, collaborating with technology providers and trialling novel solutions are important to shape future business plans.
  • Are we engaging in policy development? This is a critical juncture in Hong Kong’s financial infrastructure regulatory development. Consultations on significant topics need a high quality of considered feedback. Industry groups have a great role to play in gathering feedback, but these often rely on a small but pivotal group of engaged institutions.
  • How can we prepare? Technology build-outs are costly and have long lead times. They may also be run from head offices in other jurisdictions. Identifying potential system upgrades early can be extremely valuable, as is maintaining a watch list of potential changes. Considering potential impacts to contracts can also be done early.
  • Where are the opportunities? Increased regulatory certainty in areas such as stablecoins and virtual assets provides a strong platform for more traditional institutions to consider how they might be involved. We are already seeing joint ventures between banks and technology companies to serve the new economy, as well as banks leveraging aspects of decentralised finance in novel transactions. With far more advanced AML/CTF controls amongst virtual asset exchanges (including on-chain analytics) banking facilities are also increasingly more common.
  • Managing residual risks. In any innovative area, there is risk. The key is to identify it, analyse it and deploy targeted strategies to mitigate it. Engaging with regulators is also a useful tool in appropriate scenarios. Considering adjacent issues such as data flows, customer expectations, tax implications, competition law and intellectual property are also important.