Original Source: Ouke Cloud Chain Research Institute
Original Author: Jason Jiang, Bi Lianghuan
Introduction
At the beginning of June, after the licensing system for virtual asset trading platforms in Hong Kong came into effect, the market gradually turned its attention to another important track in the virtual asset market: stablecoins. Hong Kong government officials have repeatedly revealed in public that Hong Kong will gradually establish a regulatory framework and officially launch a stablecoin licensing system by the end of 2024.
Due to the important role and tremendous potential of stablecoins in the digital financial ecosystem, the Hong Kong industry has started to envision the development prospects of a Hong Kong dollar stablecoin. On July 3rd, several experts and scholars who focus on Hong Kong's Web 3 published a joint article in Ta Kung Pao, strongly proposing the issuance of a Hong Kong dollar stablecoin backed by Hong Kong's foreign exchange reserves. This initiative aims to promote financial technology innovation, enhance the competitiveness of the financial market, and enable Hong Kong to maintain a competitive advantage in the digital economy era. The Ouke Cloud Chain Research Institute previously published a special article titled "Seven Questions about Hong Kong Dollar Stablecoin: Issuance Logic, Regulatory Rules, and Potential Impacts" in the most well-known financial media in the Greater China region, Finance and Economy, at the end of June, sharing observations and thoughts on the Hong Kong dollar stablecoin with the public.
The following is the original report👇👇👇
In the midst of the SEC's turmoil in the United States, on the other side of the Pacific in Hong Kong, the virtual asset and Web 3 industries are full of hope. Ashley Alder, the Chief Executive Officer of the Securities and Futures Commission of Hong Kong, previously stated in a speech at the Annual Conference of the Hong Kong Investment Funds Association, "The Securities and Futures Commission of Hong Kong is committed to promoting growth. We understand that investment products in the market need to innovate in order to keep up with the times and meet the ever-changing needs of investors. We are currently focusing on three main areas: Environmental, Social, and Governance (ESG), virtual assets, and Renminbi-denominated products." Hong Kong's regulation of virtual assets is being carried out in an orderly manner, gradually delving into the branches of virtual assets, such as the long-awaited "Hong Kong stablecoin." On June 5th, Eddie Yue, the Chief Executive of the Hong Kong Monetary Authority, stated that the Hong Kong Monetary Authority has formulated a regulatory framework for stablecoins and plans to conduct a second round of public consultation within this year. This article will start with seven basic questions to interpret the issuance logic, technical framework, regulatory rules, and potential influence of the Hong Kong stablecoin. Taking USDC as an example, it will analyze the operational mechanism that the Hong Kong stablecoin can refer to in the future.
Seven Questions about the Hong Kong Stablecoin
Question 1: Why is the stablecoin receiving so much attention?
Answer: The reasons for the stablecoin receiving so much attention are as follows:
1. It plays an important role in the crypto economy. In the early days of virtual asset trading, it was priced in Bitcoin. However, due to the high volatility of Bitcoin and the cutoff of fiat currency channels due to regulations, USDT and other US dollar stablecoins emerged. Stablecoins not only serve as a bridge between the crypto market and the fiat system, becoming an important medium for virtual asset trading, but also provide liquidity for innovative ecosystems such as DeFi and NFT. According to incomplete statistics, the average quarterly trading volume of stablecoins in 2021 is comparable to the trading volume of stocks on the New York Stock Exchange during the same period. As of now, the market value of stablecoins is close to 130 billion US dollars, a 376.19% increase from 2020, accounting for 11.67% of the total market value of virtual assets. Among the top 5 virtual assets calculated by market value, 2 of them are stablecoins.
Stablecoin Market Trends (Revised Chart)
Proportions of Stablecoins Supported by Different Fiat Assets
2. Strong connection with traditional finance. Since the release of the Libra (now Diem) white paper by FaceBook (now Meta) in 2019, traditional finance and technology companies have continued to pay attention to stablecoins. Stablecoins combine fiat credit with blockchain credit enhancement, making them more easily accepted by traditional markets compared to other virtual assets. They have a higher possibility of integrating into daily economic activities and mainstream financial systems. Many institutions are currently attempting to use stablecoins to provide inclusive financial services to users who cannot access bank accounts, supplementing and improving the existing financial service system.
Main Use Cases of Stablecoins at Present
3. Frequent risk events posing threats to financial stability. Whether it is the Luna bankruptcy incident or the more common phenomenon of stablecoin deviations, it indicates that the current stablecoin market still faces many risks. Particularly considering that mainstream stablecoins are tied to the high liquidity of real-world financial assets in various countries, their correlation with traditional financial markets is deepening. Therefore, stablecoins may become the main channel for the transmission of financial risks, posing potential threats to global financial stability.
Question 2: How will Hong Kong regulate stablecoins?
Answer: Hong Kong may take the following measures:
1. Regulatory sandbox. Referring to the previous development approach in Hong Kong, while formulating a regulatory system for stablecoins, the Monetary Authority may adopt a regulatory sandbox to pilot-test the compliant issuance and operation of stablecoins, providing practical basis for subsequent comprehensive regulation.
2. Licensing system. The Monetary Authority will use licenses as the main tool to regulate stablecoins. Entities engaged in stablecoin-related activities in Hong Kong or promoting such activities to the Hong Kong public, as well as entities conducting activities related to stablecoins pegged to the Hong Kong dollar, should hold a license. However, having a license does not guarantee everything will be fine. For different aspects such as issuance, governance, custody, and wallet services related to stablecoins, the Monetary Authority will use different license requirements to regulate different activities. Business restrictions will also apply, which means institutions engaged in issuance cannot simultaneously provide custody services, implying that compliant issuance of stablecoins in Hong Kong requires the collaborative efforts of multiple licensed institutions.
3. Technological regulation. After the regulatory framework is established, Hong Kong will rely on regulatory technology for active and continuous monitoring and observation of the stablecoin market. By utilizing embedded regulation and other methods, more timely market information and higher-quality regulatory data can be obtained. Several countries/regions have already implemented or planned to launch such active regulatory mechanisms, and in the future, Hong Kong may introduce similar technologies in stablecoin regulation to enhance regulatory adaptability.
Question 3: How should Hong Kong dollar stablecoins be issued? How can they compete with USD stablecoins?
Answer: As long as the issuing institutions meet the licensing requirements of the Monetary Authority, theoretically they will be allowed to issue stablecoins. However, for considerations of liquidity and security, stablecoins backed by Hong Kong dollars will become an important option for compliant Hong Kong dollar stablecoins. This is because Hong Kong dollar-backed stablecoins can maintain good stability while having closer connections with traditional financial institutions and regulation, thus quickly gaining widespread user trust. From a global perspective, USDC is one of the stablecoins that has performed well in terms of compliance, and Hong Kong dollar stablecoins can to some extent refer to USDC.
But currently, 99% of the circulating stablecoins are USD stablecoins, and other fiat-backed stablecoins cannot compete with them. In addition to circulating on virtual asset trading platforms licensed by the Securities and Futures Commission of Hong Kong through non-market means, HKD stablecoins also need to attract more institutions and users through innovative mechanisms to strive for greater development space. Developing an interest-bearing HKD stablecoin backed by fiat currency may be a good choice, with HKD as the collateral asset and paying users all or part of the interest generated by the collateral, in order to gain more trust and usage from institutions and users. The interest-bearing stablecoin model has been explored in the DeFi field, and products such as eUSD launched by Lybra Finance and LSD interest-bearing stablecoin protocol launched by Prisma Finance have achieved good market response. This model may expand to the centralized stablecoin market in the future. However, if the HKD stablecoin accrues interest, its attribute definition and regulatory mechanism need to be reconsidered, because stablecoins under this model have more complex attributes and may lead to bank runs.
Interest-bearing stablecoin eUSD model
4 Questions: Which institutions can participate in the HKD stablecoin ecosystem?
Answer: Traditional financial and technology institutions are highly concerned about the stablecoin market and some have started researching and exploring stablecoin applications. In the United States, giants such as JP Morgan and PayPal have long been eager to try, and once the MiCA regulation of the European Union takes effect, banks and financial institutions will also be more interested in issuing stablecoins or providing related services. Compared to crypto companies, traditional commercial institutions have natural advantages in stablecoin risk control and applications. It is expected that more traditional financial and technology companies will emerge in the HKD stablecoin market.
Among them, Hong Kong commercial banks will play an important role in the HKD stablecoin ecosystem, and many banks may launch their own HKD stablecoin products/services. Unlike the current stablecoin applications dominated by non-bank institutions focused on virtual assets, HKD stablecoins launched by commercial banks will explore more integrated application scenarios and expand the use of stablecoins to a larger digital ecosystem, such as data assetization and real asset tokenization, etc.
But because of this, all institutions attempting to participate in the compliant Hong Kong dollar stablecoin business need to register as operating entities in Hong Kong. Only companies that are incorporated as local legal persons in Hong Kong can apply to the Hong Kong Monetary Authority for relevant licenses and operate in accordance with the law. Foreign companies' branches or offices in Hong Kong cannot apply for licenses and therefore cannot participate in the issuance and operation of Hong Kong dollar stablecoins.
Stablecoin giants (part)
5 Questions: Which sub-markets are worth paying attention to when issuing Hong Kong dollar stablecoins?
Answer: The following sub-markets are worth paying attention to:
1. Hong Kong dollar stablecoin payments. The Hong Kong dollar stablecoin will be used as a payment tool rather than an asset, which means it will be used more for commercial payments. Hong Kong fintech companies that are closely linked to merchants and consumers and have extensive participation from commercial banks will have a broad market space because they can innovate faster than banks and provide consumers and merchants with better stablecoin payment services through the open stablecoin network provided by banks.
2. Risk control and compliance services. Third-party risk management and compliance services related to Hong Kong dollar stablecoins will be increasingly favored. Although there are already third-party risk management companies such as stablecoin audits, advisors, and insurance providers, considering the future regulatory framework in Hong Kong, Hong Kong dollar stablecoins need more efficient and proactive risk control and compliance tools to monitor and regulate the market. If the Hong Kong dollar stablecoin is issued on a public blockchain, its transaction and circulation data will be presented as on-chain data, and using blockchain data analysis technology for on-chain AML and smart alert analysis will become an important choice to provide industry standards and transparency.
6 Questions: What is the relationship between Hong Kong dollar stablecoins and tokenized deposits and digital Hong Kong dollars?
Answer: 1. Hong Kong dollar stablecoins and tokenized deposits. They have a certain competitive relationship, and before the compliance framework for Hong Kong dollar stablecoins is clear, tokenized deposits may become an alternative solution to connect the fiat system in Hong Kong's Web 3. Tokenized deposits are essentially the digital representation of deposits held by financial institutions, with commercial banks as the main body and using bank deposits as collateral. They can be seen as intermediaries between CBDCs and private stablecoins. Singapore and the United States have previously made positive explorations in the field of tokenized deposits, and globally renowned credit rating agency Moody's believes that tokenized deposits have the potential to be an alternative solution to address the shortcomings of stablecoins.
Hong Kong has been exploring tokenized deposits in the Cyberport Token Pilot Program and considering appropriate regulatory measures. If tokenized deposits led by commercial banks are successful in the pilot project in Hong Kong, it may provide technical and experiential support for the subsequent launch of Hong Kong dollar stablecoins, but it may also diminish the enthusiasm for exploring Hong Kong dollar stablecoins because tokenized deposits can fulfill most of the functions of Hong Kong dollar stablecoins while addressing their challenges.
2. Hong Kong dollar stablecoins and digital Hong Kong dollars. The biggest difference between the two is that digital Hong Kong dollars will be issued under the supervision of the Hong Kong Monetary Authority and will have the same legal currency status as Hong Kong dollars, while Hong Kong dollar stablecoins will be issued by private institutions or commercial banks and will only exist in the short term as payment tools or digital assets.
Comparison between CBDCs, stablecoins, and tokenized deposits
7 Questions: Does Hong Kong Need Hong Kong Dollar Stablecoins?
Answer: As Web 3 relies on stablecoins for payment settlement, Hong Kong dollar stablecoins are an important infrastructure for promoting the development of Web 3 in Hong Kong and facilitating cross-border trade settlement in Hong Kong dollars. They can truly keep Web 3 innovation in Hong Kong. If Hong Kong dollar stablecoins are successfully launched, they will not only connect the virtual asset market with the Hong Kong financial market, attract more talent and capital, but also enhance Hong Kong's influence in the field of virtual assets and Web 3. Therefore, the market has a high enthusiasm for the launch of Hong Kong dollar stablecoins.
However, there is almost no mention of Hong Kong dollar stablecoins in the current official statements from Hong Kong. Instead, there is more encouragement to promote innovative practices such as digital Hong Kong dollars and tokenized deposits. At the same time, considering that the Hong Kong government is accelerating the formulation of stablecoin regulatory policies, it may take some time before the implementation of regulations. Therefore, in the short term, the Hong Kong government may not have a strong demand for Hong Kong dollar stablecoins, and the possibility of compliant Hong Kong dollar stablecoins appearing is not high.
One of the reasons for the difference in attitudes between regulators and the market towards Hong Kong dollar stablecoins is that they have different priorities for compliance and efficiency under different perspectives. Regulators are more concerned with achieving a balance in compliance, risk control, and market innovation. In the absence of solutions to real-world problems such as anti-money laundering, Hong Kong dollar stablecoins are not a necessity for regulators.
The Future of Hong Kong Dollar Stablecoins as Seen through the Compliance of USD Coin
USD Coin (USDC) is a centralized stablecoin endorsed by the U.S dollar, pegged at a 1:1 ratio. It has gained widespread adoption and recognition. According to a recent report by Kaiko, during the ongoing drama surrounding the U.S. debt limit, both USDT and USDC have remained stable, indicating investors' confidence in stablecoins' stability. Currently, the market value of USDC has reached $28.782 billion, and its product architecture and operational mechanisms have stood the test of time. The issuer of USDC is also continuously expanding its business scope to include banking and other industries, making compliance the foundation of USDC's development. Through long-term practical experience, USDC has established corresponding compliance and risk control mechanisms, which can be a source of reference for the issuance and operation of Hong Kong dollar stablecoins.
Let's first analyze the operation mechanism of USDC. When users deposit dollars in exchange for USDC, USDC is issued on the Ethereum network, and the corresponding assets are mortgaged and stored in storage accounts in a 1:1 relationship. Conversely, USDC is reduced and destroyed to allow users to withdraw USDC. From a product architecture standpoint, besides the token issuance smart contract, the storage contract is also one of the important contracts of USDC. As an example of a purchase, when users buy USDC, the amount of USDC they purchase will be frozen and stored in the USDC storage contract. The storage contract also regulates the issuance of USDC to ensure stability. USDC stores the fiat currency assets it collaterals in accounts provided by the Federal Deposit Insurance Corporation (FDIC) and other institutions for decentralized storage to ensure asset security. The reserve funds of USDC belong to USDC holders, not Circle, and are all stored in a dedicated account designated for the "benefit of USDC holders." This is different from banks, where banks can use depositors' funds for lending and other activities.
The issuance and operation mechanism of USDC
In terms of risk management, USDC as an electronic "storage" tool is regulated by state currency transmission laws. In addition to external regulation, there are third-party validators who conduct regular audits of the code and finance. In internal risk management, USDC has four sections: "risk advisory", "fraud management", "monitoring plan", and "complaint management". In terms of compliance management, the issuing organization of USDC will comply with regulatory requirements, carry out KYC/AML, and establish corresponding risk control systems.
The development and operation of HKD stablecoin should also follow this approach. Risk management will be the first line of defense for the security of virtual assets, and compliance management is the first step that cannot be bypassed in the development of HKD stablecoin. In the process of compliance management, especially for the internal compliance management of on-chain assets, traditional financial AML tools may fail.
For on-chain assets, your wallet address is an account. Unlike regular bank accounts, this address usually does not require personal information, so a compliance technology solution for virtual assets is necessary. Taking Onchain AML solution of Onchain Cloud Chain as an example, in response to the new requirements of virtual assets, the traditional KYC part has been upgraded to KYA (Know Your Address) and KYT (Know Your Transaction). KYA, accumulated through long-term practice and using machine learning and multimodal algorithms, accurately identifies various address labels, and the address label library of more than 30 trillion addresses can effectively enable enterprises to achieve internal compliance management. KYT can detect the transaction risk of each transaction in real time, fully understand the transaction information, and thereby meet the compliance and risk control needs of virtual asset service providers.
Conclusion
In the Web 3 world, the Hong Kong model is attracting widespread attention. The core of the Hong Kong model lies in compliant transactions. As a key financial infrastructure in the Web 3 era, stablecoins, including Hong Kong dollar stablecoins, need to be based on safety and compliance. However, in reality, the difficulty of launching Hong Kong dollar stablecoins does not lie in the market-oriented procedures such as issuance and operation, but in whether there can be compliance technology and services that meet Hong Kong regulatory requirements to solve challenges such as anti-money laundering and anti-terrorism financing. Similar to the regulatory framework for virtual asset trading service providers, when regulating Hong Kong dollar stablecoins, licenses are just the foundation. The key is to use regulatory technologies and compliance tools such as Ontology-AML to monitor market changes and take corresponding measures to ensure that regulatory innovations keep up with technological innovations.
In the current shift from stock competition to incremental competition in the global virtual asset and Web 3 market, balancing compliance and innovation needs has become an important issue in the process of integrating with the real world. However, the conflict of interests between the Web 3 world and real-world regulations is becoming increasingly intense, and the sustained pressure from countries like the United States has put many crypto companies in a passive position. Compared to institutions like the U.S. SEC, Hong Kong's current regulations are more flexible, not only open and transparent but also actively seeking regulatory adaptability to changes. This friendly and adaptive regulation may promote the Hong Kong model to become a model for global virtual asset and Web 3 regulation and development.
