The Deluge is Coming Hong Kong Fires the First Shot at Stablecoin Regulation

The Storm is Approaching Hong Kong Takes Aim at Stablecoin Regulation

Source: Xiao Sa lawyer

On August 15, 2023, the Monetary Authority of Singapore (MAS), a leading global regulatory agency, announced regulations for stablecoin regulation, which includes stablecoins as a form of virtual currency that requires special regulation within the country’s financial regulatory system. After the JPEX incident, the Hong Kong region of China also recognized the harm caused by unregulated virtual asset service providers (VASPs) and began preparations to include stablecoins in the existing regulatory framework.

Today, the Sa Sister team will analyze the current regulatory rules for stablecoins in Hong Kong, as well as the possible future regulatory systems, and analyze the experimental regulations of relevant countries and regions to see what impact they may have on mainland China in the future.

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01 What is a stablecoin?

I believe everyone remembers the Silicon Valley Bank’s collapse incident in April of this year. At that time, Circle, one of the leading stablecoin issuers, publicly announced that approximately $3.3 billion of its $40 billion USDC reserves were held in the Silicon Valley Bank. The news caused an immediate drop in the price of USDC. Without a series of rescue plans, the USDC would have continued to deviate from its peg, triggering a run on the stablecoin. Additionally, stablecoins also played a significant role in the recent largest money laundering case in Singapore, helping launder a large amount of illicit funds. So, what exactly is a stablecoin? Why should we consider special regulations for it?

To understand what a stablecoin is, we must first understand why stablecoins exist.

In 2008, BTC emerged and brought the world the far-reaching, widely applicable blockchain technology. In 2014, Ethereum, a more scalable platform for “smart contracts and decentralized applications,” was built on the foundation of Bitcoin, marking the beginning of the prosperity of the encrypted world. However, whether it’s BTC or ETH, ordinary virtual currencies without a real-world value foundation are susceptible to various influences in the secondary market, making their prices prone to significant fluctuations (even frequent halvings). This makes them more suitable as a “speculative product” accepted by a few, rather than serving as a “general equivalent” widely circulating in the market and accepted by many. This directly limits the development of the entire virtual world.

Therefore, in this situation, a special approach must be adopted to reduce the price volatility of virtual currencies, turning them into assets with stable prices and becoming an important bridge between the traditional market and the virtual asset circle. Taking reference from the traditional method of stabilizing the price of fiat currencies in the real world by anchoring them to valuable goods (such as during the Bretton Woods system when a country’s currency was pegged to gold), stablecoin issuers adopt a method of issuing and storing virtual coins of equal value to fiat currencies (for example, issuing 1 virtual coin and depositing 1 unit of fiat currency in a certain bank), achieving the anchoring of stablecoins to fiat currencies and thereby stabilizing the prices of related virtual currencies.

02 Hong Kong Attitude towards Stablecoin Regulation

In general, currently Hong Kong does not allow retail trading of stablecoins, nor does it allow virtual asset service providers to offer derivative financial services such as mortgage and pledge to ordinary investors.

Stablecoins play an important role in the entire virtual asset ecosystem in terms of value circulation. It can be said that compared to BTC and ETH, stablecoins have more potential to disrupt the traditional financial system. The Hong Kong Monetary Authority (HKMA) also understands the value and risks of stablecoins. On August 25, 2023, the HKMA stated that it is studying the establishment of a regulatory framework for digital Hong Kong dollars or stablecoins, as well as promoting the application of distributed ledger technology (DLT) in the industry to tokenize bank deposits. However, the HKMA also made it clear that there is no timeline for promoting the tokenization of deposits, and it will not require all banks to follow suit. The progress will not be linked to the research on digital Hong Kong dollars, and the two will proceed in parallel.

Referring to a consultation paper on stablecoin regulation issued by the HKMA in early 2023 (which aims to consult on the necessity, feasibility, and regulatory measures of stablecoin regulation). The HKMA has already indicated its position in the paper: to incorporate stablecoins into the existing licensing regulatory system, and may establish relevant regulatory regimes as early as next year. The SA Team believes that due to the impact of several recent money laundering cases in the virtual asset community, there may be a second round of consultation on stablecoin regulation this year.

In October 2023, Hong Kong’s Financial Secretary Christopher Hui stated that before officially regulating stablecoins, Hong Kong will temporarily not allow stablecoins to be included in retail trading. The SA Team believes that before Hong Kong introduces clear regulations on stablecoins, previously issued stablecoins may be subject to strict regulation, so it is not advisable for partners to develop stablecoin businesses in this environment in Hong Kong. Currently licensed platforms or platforms deemed licensed only allow retail trading of BTC and ETH, and if new currencies (such as stablecoins) are added, a report must be submitted to the Securities and Futures Commission for approval before trading can take place.

03 Experimental and Demonstrative Regulation’s Impact on Mainland China

Mainland China has always adopted strict regulatory measures for cryptocurrencies and issued the “Announcement on Preventing Risks of Token Offerings and Financing” (hereinafter referred to as “September 4 Announcement”) on September 4, 2017; and the “Notice on Further Preventing and Dealing with Risks of Virtual Currency Trading Speculation” (hereinafter referred to as “September 24 Notice”) on September 24, 2021. After the release of these two regulatory documents, virtual currency-related businesses have disappeared in mainland China. However, this does not mean that cases related to virtual assets have also disappeared. In judicial practice, Chinese courts generally do not distinguish stablecoins (USDT, USDC, etc.) in nature from ordinary virtual currencies.

In the case of [2020] Yu 11 Min Zhong Zi No. 2674, Zhu’s husband signed a reception agreement with Ren on September 4, 2020 and transferred 79,596 USDT coins to Ren’s virtual wallet through an electronic wallet on the same day. The IOU stated: “Received 490,000 yuan in cash from Zhu, to be paid back in full in one week. A late fee of 5‰ will be charged for each day of delay.” Since Ren did not repay the loan on time, Zhu sued Ren in court. Subsequently, both the first-instance court and the second-instance court held that: “The appellant claims that there is a civil lending relationship between him and the respondent, but fails to provide evidence proving that he handed over cash, bills, fund accounts, etc. to the respondent or made a legal and valid electronic transfer to the respondent.” In other words, Chinese courts do not consider stablecoins as legal tender, nor do they recognize that stablecoin lending can generate legally protected creditor’s rights.

However, Chinese judicial authorities recognize stablecoins as a valuable special asset that can be realized through certain fixed channels. For example, in the case of Zhao organizing and leading pyramid selling activities [(2021)Hei.0402 Criminal Initial No. 7], the judgment stated: “After the case was discovered, the public security authorities confiscated 41,821,019 USDT coins from the defendant Zhao. After conversion and exchange, they amounted to 276,018,725.40 yuan, which were all confiscated in accordance with the law and turned over to the national treasury.”

Therefore, stablecoins can basically be regarded as a “special and valuable asset” in mainland China, but the relevant transaction regulations are not clear, posing risks of being unprotected by the law.

The Sa Team believes that as an experimental and demonstrative virtual asset regulatory area in mainland China, the regulatory system in Hong Kong is expected to have important reference value for the future virtual currency regulatory system in China. Regarding the regulation of stablecoins, mainland China may distinguish the regulation of stablecoins and regular virtual currencies in the near future, and a key breakthrough will be the disposal of virtual currencies involved in cases.

On August 25, 2023, the Finance Department of Shandong Province and 17 other departments jointly issued the “Notice on the Work Regulations (Trial) for Disposal of Confiscated Items in Shandong Province,” which clearly states: “Law enforcement agencies may negotiate with merchants who issue prepaid cards and virtual currencies confiscated according to law, and the merchant will make an offer for repurchase. The repurchase price shall be agreed upon by both parties and should generally not be lower than 80% of the face value or balance of the virtual currency or prepaid card. Both parties shall sign a repurchase agreement.” From this, we can see that this kind of realization system is almost tailor-made for stablecoins, while “decentralized issuers” such as BTC and ETH are difficult to acquire through resolutions.

04 The Bottom Line

In general, Hong Kong has always maintained an open and inclusive attitude towards financial innovation. The Sa Team believes that the introduction of regulatory measures for stablecoins is not far away, and it is highly probable that stablecoins will be included in the regulatory system for virtual asset licensing. Leading stablecoin companies like USDT must closely monitor the relevant regulatory measures and apply for licensing at the earliest opportunity, otherwise they may lose the vast market in Hong Kong and related regions.

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