Regulation and innovation: thoughts and prospects on Hong Kong’s Crypto compliance framework

In 2024, the international community will reach a preliminary consensus on digital financial regulation, and digital finance and related blockchain technology, smart contracts and distributed ledger technology (DLT) will form universal industry rules. As the largest offshore RMB center and international financial center, Hong Kong has unique advantages in developing technology finance and is one of the earliest regions to deploy digital finance and blockchain technology applications.

With the continuous innovation of financial technology and the rapid development of blockchain technology, multi-faceted and multi-level links have emerged between digital finance and traditional finance. Against this background, a regulatory system for digital finance and crypto assets is urgently needed. Hong Kong was the first region in the world to propose a comprehensive investor protection policy for digital finance in 2018, and officially released the "Consultation Document on Legislative Proposals for the Implementation of a Regulatory System for Stablecoin Issuers in Hong Kong" in December 2023, and launched the "Sandbox" system for stablecoin issuers in March 2024 [1].

How should digital finance and crypto assets be regulated? Who regulates them? What laws and systems apply? How to identify and regulate digital cross-border transactions? How to achieve investor protection? These issues are brand new in the context of blockchain technology and are issues that have never been encountered in traditional financial regulation. It is necessary to balance the relationship between regulation and innovation. The international community has discussed this issue a lot, with great differences and even sharp opposition on some key issues. The U.S. House of Representatives voted to pass the 21st Century Financial Innovation and Technology Act (FIT21) in May this year, which has become a reference for the formulation of regulatory frameworks in other parts of the world. In the context of the introduction of the FIT21 Act, this article combines the key points of the relevant regulatory framework that has been announced in Hong Kong, sorts out the connotation and classification of crypto assets, summarizes the key points and main opposing views of the FIT21 Act, and puts forward some thoughts and prospects for the introduction of the next regulatory details in Hong Kong.

Crypto assets and stablecoins

Crypto assets are a subset of digital assets. There is no unified definition of crypto assets. In some applications, they are also called virtual assets, and their structure, nature and use also show great differences. Crypto assets cover a very wide range, including investment-related tokens, stablecoins, functional tokens and non-fungible tokens.

The type of crypto asset that is most directly linked to traditional finance is digital stablecoins. Digital stablecoins are generally anchored to fiat currencies, or linked to single or multiple assets. Since there is currently no mature regulatory framework for digital stablecoins worldwide, the value support mechanism of some stablecoins in reality is not transparent, and some stablecoins are not stable. There have been malicious incidents of stablecoin collapse in the past, such as the Terra Luna stablecoin collapse in May 2022.

From the perspective of the blockchain operation mechanism, there are usually three types of digital stablecoins: the first type is a stablecoin with fiat currency as reserve support (such as USDT issued by Tether and USDC issued by Circle). Such stablecoins are usually centralized, with prices anchored to fiat currency and can be exchanged with fiat currency at a 1:1 ratio. The second type is a stablecoin with cryptocurrency as reserve support (such as DAI issued by MakerDao). In this model, the reserve assets are held by smart contracts (Protocols), mostly decentralized stablecoins, and the types and quantities of reserve assets are relatively transparent. Users can deposit crypto assets as collateral in exchange for digital stablecoins, or reverse operations to redeem digital collateral. Since the value fluctuations of crypto assets used as collateral are usually large, in order to maintain the relative stability of the stablecoin price, users usually need to deposit digital collateral in excess at a ratio higher than 1:1. The third type is algorithm-based stablecoins (such as LUNA issued by Terra, FEI issued by Fei Labs, etc.). These stablecoins maintain their relationship with anchor assets through complex algorithmic rules and stabilization mechanisms of blockchains. They usually do not have reserve assets corresponding to the value of stablecoins, so these stablecoins are often unstable. Regulatory legislation for stablecoins is the most critical link in forming and improving the digital financial regulatory framework. The current stablecoin regulatory frameworks that governments are planning to introduce are mainly aimed at the first two types mentioned above.

Hong Kong SAR Digital Finance Regulatory Framework

Hong Kong is one of the earliest regions to deploy the blockchain crypto asset industry. The Hong Kong Monetary Authority began research on Distributed Ledger Technology (DLT) as early as 2016 and released its first blockchain white paper. In 2019, the Hong Kong Monetary Authority and the Bank of Thailand jointly carried out the mCBDC Bridge Project to study the application of central bank digital currencies in cross-border payments at the wholesale level. The project was strongly supported by the Hong Kong Center under the Innovation Hub of the Bank for International Settlements and was expanded to the Digital Currency Research Institute of the People's Bank of China and the Central Bank of the United Arab Emirates in February 2021. In June 2021, the Hong Kong Monetary Authority announced the "Hong Kong Fintech 2025" strategy to promote the development of digital financial technology in Hong Kong.

At present, the international market value of crypto assets has increased significantly, which reflects the increasingly close relationship between the crypto asset industry and the mainstream financial system. On December 27, 2023, the Hong Kong Monetary Authority launched a consultation on the legislative proposal for the implementation of the regulatory system for stablecoin issuers and announced the launch of the "Sandbox" arrangement (original HKMA consultation proposal). The consultation document reflects a series of arrangements based on risk management and the principle of "same risk, same regulation" to regulate related institutions and activities. The proposed digital asset regulatory framework will focus on the impact of three aspects: (1) the stability of the Hong Kong SAR monetary and financial system; (2) user and investor protection; (3) fraud and money laundering activities that may be involved in digital asset transactions. From the perspective of the specific implementation of the regulatory system, the current regulatory framework for crypto assets will focus on three aspects: (1) formulating a regulatory system for "digital stablecoins for payment purposes"; (2) emphasizing investor protection in the crypto asset industry; and (3) regulating the related businesses and transactions of registered institutions and crypto assets to ensure the stability of the monetary and banking system in Hong Kong. This regulatory consultation opinion and the "sandbox" arrangement clearly put forward the Hong Kong SAR's views and operating guidelines on financial technology, digital finance and crypto assets, and promoted the formation of industry consensus and international standards. In view of the recent passage of the US "FIT21" bill in the House of Representatives, the Hong Kong SAR also needs to introduce its own regulatory details at this time of in-depth discussion of international rules.

Discussion on the US "FIT21" Act

There is considerable controversy over the regulation of crypto assets internationally, involving discussions on the attributes of digital assets, such as whether digital assets are commodities or securities, which asset types should be regulated by the Securities and Exchange Commission, which categories should be regulated by the Commodity Futures Commission, and the cross-regulation issues between the two.

On May 22, 2024, the U.S. House of Representatives passed H.R.4763, the Financial Innovation and Technology for the 21st Century Act (FIT21 Act) with 279 votes in favor and 136 votes against (House of Representatives voting results). The bill will revise existing U.S. securities and commodity regulatory laws and regulations to promote the application of digital assets.

The "FIT21" bill has sparked widespread discussion internationally. It has officially pushed the regulatory issues of the crypto asset industry into the legislative process and launched policy-level discussions on some highly controversial issues. At present, the "FIT21" bill has not been formally passed, and will be voted on in the Senate in the future. At present, there is constant heated discussion and controversy about the bill. First, the U.S. Securities and Exchange Commission (SEC) has expressed its firm opposition to the "FIT21" bill. SEC Chairman Gary Gensler issued a statement (the original text of the SEC statement) that the bill would undermine the investor protection system and that the new digital regulatory bill is not very necessary. Secondly, U.S. President Joe Biden does not support the current form of legislation. Before the House vote, the White House issued an administrative policy statement (the original text of the White House statement) indicating that the White House opposes the passage of "FIT21.SAP", saying that "the government is eager to work with Congress to ensure that digital assets have a comprehensive and balanced regulatory framework based on the current system, but 'FIT21' lacks sufficient protection for consumers and investors."

We have studied the details of the "FIT21" bill in detail, and compiled the mainstream views supporting or opposing the bill based on the policy communication documents issued by different US government agencies. The "FIT21" bill will provide a useful reference for Hong Kong to introduce its own regulatory details in the next step. In summary, the main views supporting "FIT21" are: (1) The "FIT21" bill clarifies the jurisdiction of the US Securities and Exchange Commission (SEC) and the US Commodity Futures Trading Commission (CFTC), avoiding the ambiguity and disputes between the two regulatory boundaries; (2) The bill fills the current regulatory gap in the digital commodity spot market; (3) The bill can promote innovation in the digital financial field because it clarifies the responsibilities and obligations that cryptocurrency intermediaries and entrepreneurs need to bear; (4) The bill clarifies that digital currency intermediaries should be subject to the Bank Secrecy Act, solving the problem of anti-money laundering; (5) The bill protects the interests of investors. For example, the bill formulates operating rules for digital asset intermediaries, including prohibiting mixed sources of funds and increasing information disclosure requirements for digital assets.

At the same time, the main arguments against "FIT21" are that: (1) the bill undermines existing securities laws because "FIT21" gives cryptocurrency companies and crypto assets more relaxed rules than traditional securities markets; (2) the bill fails to adequately protect digital asset investors and customers of digital asset companies; and (3) the bill fails to adequately address the problem of illegal financing.

Since there are many differences between the crypto asset industry and traditional finance, FIT21 proposes regulatory details for new issues that will not arise in traditional finance, and puts forward regulatory opinions on issues that are currently controversial internationally. We summarize the key points and innovations of the FIT21 bill as follows. First, FIT21 clarifies the regulatory framework for digital stablecoins, which is a useful reference for the "sandbox" system to be launched in Hong Kong. FIT21 defines "stablecoins for payment purposes" as digital assets issued by issuers regulated by federal or state regulators and having the following characteristics: (1) used or designed as a means of payment or settlement; (2) the issuer is obliged to redeem at a fixed monetary value while maintaining the stable value of the digital asset (relative to the monetary value of a fixed amount); (3) does not include (a) domestic currency or (b) securities issued by registered investment companies.

Second, the "FIT21" Act clarifies the difference between "digital assets" and "digital commodities". The main criteria for distinguishing between the two are: (1) the level of decentralization and functionality of the underlying blockchain system of the digital asset; (2) the method by which the end user obtains the digital asset; and (3) the nature of the user who holds the digital asset. For example, if the issuance of digital assets is not for fundraising purposes, that is, it only involves the exchange of the nominal value of digital assets and is equally open to all participants, or the user obtains it through a digital commodity exchange, then the digital asset is likely to meet the criteria of a "digital commodity". For another example, if the issuance of digital assets does not rely on a decentralized blockchain protocol and the issuance of digital assets has the purpose of fundraising, it is likely to be identified as a "restricted digital asset".

In addition, "FIT21" creates a self-certification procedure for "digital commodities", under which anyone can submit a certificate to the SEC (not the CFTC) that the blockchain involved in the digital asset is a decentralized system. The SEC will have 60 days to refuse certification before assets on such systems are deemed "digital commodities" subject to the jurisdiction of the CFTC. Under this procedure, "restricted digital assets" can initially be issued as a security (i.e., subject to the disclosure and issuance requirements of the SEC, similar to traditional securities) and then be transformed into "digital commodities" through a self-certification procedure. Currently, Hong Kong has approved the issuance of Bitcoin and Ethereum spot ETFs. The subsequent regulatory principles for such products all rely on the determination of whether such products are securities or commodities. The certification rules proposed by "FIT21" are an important reference for the listing and supervision of subsequent blockchain products in Hong Kong.

Third, "FIT21" clearly clarifies for the first time the regulatory responsibilities of the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) for digital assets (the two often "fight"), and requires the updating and supplementation of the current securities and commodity laws to establish a federal digital asset regulatory framework for various blockchain technology applications (including various decentralized protocols). According to the bill, "restricted digital assets" are regulated by the SEC; "digital commodities" are regulated by the CFTC; "stable coins used for payment purposes" should be subject to the jurisdiction of the SEC or the CFTC according to the nature of the trading intermediary. At present, Hong Kong has approved the issuance application of Bitcoin and Ethereum spot ETFs. The subsequent regulatory principles for such products depend on the determination of whether such products belong to securities or commodities, and the division of corresponding regulatory procedures. The operating rules proposed by "FIT21" are an important reference for the listing and supervision of subsequent blockchain products in Hong Kong.

Fourth, "FIT21" clarifies the definition and registration requirements of digital asset intermediaries. The bill requires digital asset intermediaries (i.e., institutions that trade, transfer, facilitate transactions, clear or custody digital assets) to register with the U.S. Securities and Exchange Commission (SEC) or the U.S. Commodity Futures Trading Commission (CFTC) based on the type of digital assets they trade ("restricted digital assets" or "digital commodities"). The contents include: (1) The SEC will supervise qualified digital asset custodians, digital asset brokers, digital asset traders and digital asset trading systems for "restricted digital assets". (2) The CFTC will supervise "qualified digital asset custodians" for "digital commodities", digital commodity exchanges, digital commodity brokers, and digital commodity traders; (3) The bill requires the SEC and CFTC to formulate rules for dual registration of intermediaries and related institutions; (4) The bill clarifies that digital asset intermediaries must be subject to anti-money laundering laws and must comply with the provisions of the Bank Secrecy Act regarding "financial institutions".

Thinking and Outlook

At present, the development of blockchain technology has entered the fast lane, the ecosystem has taken shape, and an international consensus on rules has gradually been formed. In terms of public blockchain, the world-class public chain "Conflux Network" developed by Professor Yao Qizhi of the Chinese Academy of Sciences and Tsinghua University has attracted widespread attention internationally. Many Chinese and international web 3.0 companies have deployed blockchain second-layer networks and related applications on the Conflux public chain. As one of the earliest regions to promote digital finance, Hong Kong has attracted global attention in terms of market openness and inclusiveness. The Hong Kong Monetary Authority's "pioneering" initiative to propose a digital financial regulatory framework has become a powerful manifestation of Hong Kong's international competitiveness.

Regulation and innovation are a dynamic balancing process. The profound impact of blockchain technology on financial market reform is widely recognized internationally, but it is not certain whether all traditional financial services will be put on the blockchain and implemented through smart contracts and distributed ledger technology (DLT). This remains to be seen. This also means that the regulation of digital finance is a process of continuous updating and improvement, and the current international experience is an important reference.

Hong Kong has always adopted the concept of "same business, same regulation" and has been cautiously neutral to technology, which is also the core regulatory thinking for a healthy balance between innovation and regulation. For digital finance, Hong Kong has basically adopted the same principles for regulating exchanges and brokers, and has also adopted the same regulatory requirements for licensed institutions. As the US "FIT21" bill officially enters the legislative process, the digital financial industry will quickly reach a general consensus on the core elements internationally, and the market will also form clearer industry rules based on this consensus. It is necessary for Hong Kong to more clearly define the regional regulatory details at the time when international rules are formed, create a competitive ecological environment for digital finance, and further consolidate its position as an international financial center.

[1] Sandbox is an emerging regulatory term in the field of fintech. The original meaning of "sandbox" is a place where children play with sand and mud, allowing people to play and unleash their creativity in a limited and safe environment. In the field of fintech, "sandbox" mainly refers to regulators allowing financial institutions to test and collect data and user opinions in a risk-controlled and small-scale environment before launching new services and products, thereby speeding up the launch of related products and services and ensuring that the services and products meet regulatory requirements.