Okey Cloud Chain Research Institute: In-depth interpretation of issuance logic, regulatory rules and potential impact

2023-07-05 08:13:17

Original source: Okey Cloud Chain Research Institute

Original Author: Jason Jiang, Bi Lianghuan

Preface

In early June, after the Hong Kong virtual asset trading platform licensing system 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 will officially launch a stablecoin licensing system by the end of 2024.

Due to the important role and huge potential of stablecoins in the digital financial ecology, the Hong Kong industry began to imagine the development prospects of Hong Kong dollar stablecoins. On July 3, a number of experts and scholars concerned about Hong Kong's Web 3 published a joint article in "Ta Kung Pao", strongly proposing that the Hong Kong SAR government issue a Hong Kong dollar stable currency backed by Hong Kong's foreign exchange reserves to promote financial technology innovation and enhance financial market competition to enable Hong Kong to maintain its competitive advantage in the digital economy era. At the end of June, the Okey Cloud Chain Research Institute also published a special article entitled "Seven Questions on Hong Kong Dollar Stablecoin: Issuance Logic, Regulatory Rules and Potential Impact" on Caihua News, the most well-known financial media in Greater China, and communicated with all walks of life. Share your observations and thoughts on Hong Kong dollar stablecoins.

The following is the original report 👇👇👇

While the US SEC is in full swing, the virtual assets and Web 3 industries on both sides of the Pacific Ocean are full of hope. Leung Fung-yee, chief executive of the Hong Kong Securities Regulatory Commission, previously delivered a speech at the annual meeting of the Hong Kong Investment Fund Association, saying, "The Hong Kong Securities Regulatory Commission is committed to promoting growth. We understand that investment products in the market must innovate to keep pace with the times and cater to investors. We are currently focusing on three major areas: environment, society and governance (ESG), virtual assets, and RMB-denominated products.” The supervision of virtual assets in Hong Kong is being carried out in an orderly manner, and it is gradually deepening into the branch of virtual assets. Such as the "Hong Kong dollar stable currency" that the market has been looking forward to. On June 5, Hong Kong Financial Services and Treasury Secretary Xu Zhengyu said that the Hong Kong Monetary Authority has drawn up a regulatory framework for "stable coins" and plans to conduct a second round of public consultation within this year. This article will start from 7 basic issues to explain the issuance logic, technical framework, regulatory rules and potential impact of the Hong Kong dollar stablecoin, and take USDC as an example to analyze the future operating mechanism of the Hong Kong dollar stablecoin.

Seven Questions Hong Kong Dollar Stablecoin

1 Q: Why are stablecoins getting so much attention?

Answer: The reasons why stablecoins have attracted much attention are:

Play an important role in the encryption economy. Virtual asset transactions were denominated in Bitcoin in the early days, but due to the high volatility of Bitcoin and the cut-off of legal currency channels due to supervision, USDT stablecoins represented by USDT have emerged one after another. Stablecoins are not only a bridge between the encrypted market and the legal currency system, but also an important medium for virtual asset transactions, and also provide most of the liquidity for innovative ecosystems such as DeFi and NFT. According to incomplete statistics, the average quarterly trading volume of stablecoins in 2021 is almost equivalent to the trading volume of stocks on the New York Stock Exchange in the United States during the same period. As of now, the market value of stablecoins has approached US$130 billion, an increase of 376.19% compared to 2020, accounting for 11.67% of the total market value of virtual assets. 2 of the top 5 virtual assets by market capitalization are stablecoins.

Stablecoin market capitalization trend (redrawing)

Proportion of Stablecoins Backed by Different Fiat Assets

Close connection with traditional finance. Since Facebook (now Meta) released the Libra (now Diem) white paper in 2019, traditional financial and technology companies have continued to pay attention to stablecoins. Stablecoins combine fiat currency credit with blockchain credit enhancement functions, which are easier to be accepted by traditional markets than other virtual assets, and are more likely to integrate daily economic activities with the mainstream financial system in the future. At this stage, many institutions are also trying to use stablecoins to provide inclusive financial services for users who cannot use bank accounts, supplementing and improving the existing financial service system.

Main use cases of stablecoins at this stage

Frequent occurrence of risk events poses a threat to financial stability. Whether it is the Luna thunderstorm incident or the more frequent stablecoin unanchoring phenomenon, it shows that the current stablecoin market still faces many risks. Especially considering that the current mainstream stablecoins are all related to the highly liquid real financial financing of various countries, and the correlation with the traditional financial market is also deepening. Therefore, it may become the main diffusion channel of financial risks and pose a potential threat to global financial stability.

2 Q: How will Hong Kong regulate stablecoins?

A: Hong Kong may take the following measures:

Regulatory sandbox. Referring to Hong Kong’s previous development ideas, while formulating the stablecoin regulatory system, the HKMA may adopt a regulatory sandbox to conduct pilot tests on stablecoin compliance issuance and operation activities, providing a practical basis for subsequent comprehensive supervision.
Licensing system. The Monetary Authority will use licenses as the main tool for regulating stablecoins. All entities that engage in stablecoin-related activities in Hong Kong or promote related activities to the Hong Kong public, as well as any entity that conducts activities related to Hong Kong dollar-pegged stablecoins, should hold a license. But not a license is all right. For the different links involved in the issuance, governance, custody and wallet services of stablecoins, the HKMA will regulate different activities with different licenses. At the same time, the main business is restricted, that is, the institutions engaged in the issuance business cannot provide custody services at the same time, which means that the issuance of compliant stablecoins in Hong Kong requires the cooperation of multiple licensed institutions.
Technical supervision. After the regulatory framework is formulated, Hong Kong will rely on regulatory technology to actively and continuously monitor and observe the stablecoin market. Obtain more timely market information and higher quality regulatory data through embedded regulation and other models. At present, some countries/regions have implemented or plan to introduce such active regulatory mechanisms. In the future, Hong Kong may introduce similar technologies in stablecoin regulation to improve regulatory adaptability.

3 Q: How should the Hong Kong dollar stable currency be distributed? How can it compete with USD stablecoins?

Answer: As long as the issuer meets the licensing requirements of the HKMA, it will theoretically be allowed to issue stablecoins. However, due to liquidity and security considerations, stablecoins backed by Hong Kong dollars will become an important option for compliant Hong Kong dollar stablecoins. This is because the stable currency backed by the Hong Kong dollar can maintain better stability while having a closer relationship with traditional business organizations and supervision, and quickly gain the trust of a wide range of users. From a global perspective, USDC is currently one of the best stablecoins in terms of compliance, and the Hong Kong dollar stablecoin can refer to USDC to a certain extent.

However, 99% of the stablecoins currently in circulation are US dollar stablecoins, and stablecoins backed by other legal currency assets cannot compete with them. In addition to circulating the Hong Kong dollar stable currency on the virtual asset trading platform licensed by the Hong Kong Securities Regulatory Commission through non-market means, it also needs to attract more institutions and users through mechanism innovation to strive for greater development space. It may be a good choice to develop an interest-bearing Hong Kong dollar stablecoin backed by fiat currency, that is, to use Hong Kong dollars as collateral assets and pay users all or part of the interest generated by collateral mortgages to gain the trust and use of more institutions and users. The interest-bearing stablecoin model has been explored in the DeFi field, such as the eUSD launched by Lybra Finance and the LSD interest-bearing stablecoin protocol launched by Prisma Finance, which have achieved good market response. This model may be expanded to the centralized stablecoin market in the future. However, if the Hong Kong dollar stable currency is interest-bearing, its attribute definition and regulatory mechanism need to be reconsidered, because the stable currency attributes in this model are more complicated and may cause a run on bank deposits.

Interest-bearing stablecoin eUSD model

4 Q: Which institutions can participate in the Hong Kong dollar stable currency ecology?

A: Traditional financial and technological institutions pay close attention to the stablecoin market, and some have begun to research and explore stablecoin applications. In the United States, giants such as JP Morgan and PayPal are already eager to try, and once the EU MiCA Act takes effect, banks and financial institutions will also have greater interest in issuing stablecoins or providing related services. Compared with encrypted companies, traditional commercial institutions have natural advantages in stable currency risk control and application. It is expected that more traditional financial and technology companies will appear in the Hong Kong stablecoin market.

Among them, Hong Kong commercial banks will play an important role in the Hong Kong dollar stablecoin ecosystem, and many banks may launch their own Hong Kong dollar stablecoin products/services. Unlike the current stablecoin applications dominated by non-bank institutions that are concentrated in the field of virtual assets, the Hong Kong dollar stablecoin 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 tokenization of real assets, etc.

But because of this, all institutions trying to participate in the compliant Hong Kong dollar stable currency business need to register an operating entity in Hong Kong. Only companies that have established local corporations in Hong Kong can apply for relevant licenses from the Monetary Authority and conduct business in accordance with the law. Branches or offices of foreign companies in Hong Kong cannot apply for licenses, and they cannot participate in the issuance and operation of Hong Kong dollar stable coins.

Giants who have/are/plan to issue stablecoins (some)

5 Q: If the Hong Kong dollar stable currency is issued, which subdivided tracks are worthy of attention?

Answer: The following tracks are worthy of attention:

Hong Kong dollar stable currency payment. The Hong Kong dollar stable currency will be used as a payment tool rather than an asset, which means that it will be used more for commercial payments. On the premise of extensive participation of commercial banks, Hong Kong financial technology companies that are closely connected with merchants and consumers will have a broad market space, because they innovate faster than banks, and can use the bank's open stable currency network to provide consumers and consumers Merchants provide better stable currency payment services.
Risk control and compliance services. Third-party risk management and compliance services related to Hong Kong dollar stablecoins will become increasingly popular. Although third-party risk management companies such as stablecoin audits, consultants, and insurance providers currently exist, considering Hong Kong’s future regulatory framework, Hong Kong dollar stablecoins need risk control and compliance tools that can more effectively and proactively monitor and supervise the market. For example, the Hong Kong dollar stablecoin is issued on the public chain, and its transaction and circulation data are presented on the chain. With the help of blockchain data analysis technology, AML and intelligent early warning analysis on the chain will become an important choice to provide industry norms and transparency.

6 Q: What is the relationship between Hong Kong dollar stable currency and tokenized deposits and digital Hong Kong dollar?

Answer: 1. Hong Kong dollar stable currency and tokenized deposits. There is a certain competitive relationship between the two. Before the Hong Kong dollar stable currency compliance framework is clarified, tokenized deposits may become an alternative to Hong Kong's Web 3 connection to the legal currency system. Tokenized deposits are essentially the digital expression of deposits held by financial institutions, with commercial banks as the main body and bank deposits as collateral, and can be regarded as an intermediate product between CBDC and private stablecoins. Both Singapore and the United States have actively explored the field of tokenized deposits before, and Moody’s, a world-renowned credit rating agency, believes that tokenized deposits have the potential to become an alternative solution to address the shortcomings of stablecoins.

Hong Kong has explored tokenized deposits in the Digital Hong Kong Dollar Pilot Program and is considering appropriate regulatory measures for it. If the tokenized deposit led by commercial banks is successfully piloted in Hong Kong, it may provide technical and experience support for the subsequent launch of Hong Kong dollar stable currency, but it may also reduce its enthusiasm for exploring Hong Kong dollar stable currency: because deposit tokenization can solve the problem of Hong Kong dollar stable currency While solving difficult problems, it can play most of the functions of Hong Kong dollar stable currency.

Hong Kong dollar stable currency and digital Hong Kong dollar. The biggest difference between the two is that the digital Hong Kong dollar will be issued by the Hong Kong Monetary Authority and has the same legal tender status as the Hong Kong dollar; while the Hong Kong dollar stable currency is issued by a private institution or a commercial bank organization and can only be used as a payment tool or a digital asset in the short term. exist.

Comparing CBDCs, Stablecoins, and Tokenized Deposits

7 Q: Does Hong Kong really need Hong Kong dollar stable currency?

Answer: Since Web 3 needs to rely on stable currency for payment and settlement, Hong Kong dollar stable currency is an important infrastructure to promote the localization of Web 3 in Hong Kong. Hongkong. If the Hong Kong dollar stable currency is successfully launched, it will not only connect the virtual asset market with the Hong Kong financial market, attract more talents and funds, but also further enhance Hong Kong's voice in the field of virtual assets and Web 3. Therefore, the market is extremely enthusiastic about launching Hong Kong dollar stablecoins.

However, at present, there is almost no statement about Hong Kong dollar stable currency in Hong Kong's official statement, and more is to encourage and promote innovative practices such as digital Hong Kong dollar and tokenized deposits. At the same time, considering that the Hong Kong government is speeding up the formulation of stablecoin regulatory policies, but it may take time before the regulation is implemented, the demand for Hong Kong dollar stablecoins by the Hong Kong government may not be strong in the short term, and the possibility of compliant Hong Kong dollar stablecoins appearing is not great .

The reason for the difference in regulatory and market attitudes towards Hong Kong dollar stablecoins is that the priorities for the compliance and efficiency of Hong Kong dollar stablecoins are different under different positions. Regulators pay more attention to achieving a balance in compliance, risk control and market innovation. With practical issues such as anti-money laundering unresolved, a Hong Kong dollar stablecoin is not a necessity for regulators.

Look at the future of Hong Kong dollar stable currency from the perspective of the US dollar stable currency USDC

USDC is a centralized stablecoin backed by the U.S. dollar, which is pegged to the U.S. dollar at a ratio of 1:1. It has been widely used and recognized. According to Kaiko’s recent report, USDT and USDC have shown little volatility amid the ongoing drama surrounding the U.S. debt ceiling, indicating investors’ confidence in the stability of stablecoins. At present, the market value of USDC has reached 28.782 billion US dollars, and its product structure and operating mechanism have passed the test of time. USDC issuers are also constantly expanding their business territory to banking and other businesses, and regard compliance as the development foundation of USDC. In the long-term practical experience, USDC has established corresponding compliance and risk control mechanisms, which can provide reference and reference for the issuance and operation of Hong Kong dollar stable currency.

First, analyze from the USDC operating mechanism. When a user deposits USD in exchange for USDC, USDC will be issued on the Ethereum network, and the corresponding assets will be mortgaged and stored in the storage account with a 1: 1 correspondence. Otherwise, USDC will be reduced and destroyed to allow users to withdraw USDC. From the perspective of product architecture, in addition to the token issuance smart contract, the storage contract is also one of the important contracts of USDC. Taking purchase as an example, when a user purchases USDC, the purchased USDC amount will be frozen and stored in the USDC storage contract. The storage contract is also responsible for regulating the issuance of USDC to ensure the stability of USDC. USDC deposits its mortgaged legal currency assets in the US Federal Deposit Insurance Corporation (FDIC) account and other institutions for decentralized storage to ensure the security of assets. USDC reserves are assets belonging to USDC holders, not Circle's assets, and are all deposited in separate accounts designated "for the benefit of USDC holders". This is different from banks, which can use depositor funds for businesses such as lending.

The issuance and operation mechanism of USDC

In terms of risk management, USDC is regulated by state currency transmission laws as an electronic "stored value" instrument. In addition to external oversight, there are third-party validators who conduct regular audits of code and financial aspects. In internal risk management, USDC has built four sections: "Risk Warning", "Fraud Management", "Monitoring Plan" and "Complaint Management". In terms of compliance management, the USDC issuer will follow regulatory requirements, conduct KYC/AML, and establish a corresponding risk control system.

The same should be true for the development and operation of the Hong Kong dollar stablecoin. Risk management will become the first hurdle for the safety of virtual assets, and compliance management is the first step that cannot be avoided in the development of Hong Kong dollar stablecoins. 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 ordinary bank accounts, this address usually does not require filling in personal information, so a compliance technology solution for virtual assets is very necessary. Taking the Onchain AML solution of Okey Cloud Chain as an example, in response to the new needs of virtual assets, the traditional KYC part is upgraded to KYA (Know Your Address) and KYT (Know Your Transaction). KYA has been accumulated through long-term practice and adopts machine learning and multi-mode algorithms to accurately identify various address labels. There are more than 30 trillion address label libraries that can effectively enable enterprises to achieve internal compliance management. KYT, on the other hand, can detect the transaction risk of each transaction in real time, and fully understand the transaction information, so as to meet the compliance and risk control needs of virtual asset service providers.

Conclusion

In the Web 3 world, the Hong Kong model is getting a lot of 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 premised on security and compliance in Hong Kong. But in fact, the difficulty in launching the Hong Kong dollar stablecoin at this stage is not in market-oriented procedures such as issuance and operation, but in whether there are compliance technologies and services that match Hong Kong’s regulatory requirements to solve problems such as anti-money laundering and anti-terrorist financing. Similar to the regulatory framework for virtual asset trading service providers, when imposing regulation on Hong Kong dollar stablecoins, the license is only the basis. The key is to use regulatory technology and compliance tools such as Onchain-AML to monitor market changes and take corresponding measures. Let regulatory innovation keep up with technological innovation.

As the global virtual asset and Web 3 markets are changing from stock to incremental competition, how to balance compliance and innovation needs in the process of integrating with the real world has become an important issue. However, the conflict of interests between the Web 3 world and real supervision is becoming increasingly fierce, and the continuous high pressure from the United States and other countries has made many encryption companies passive. Compared with institutions such as the SEC in the United States, Hong Kong's current regulation is more flexible. It is not only open and transparent, but also actively seeks the ability to adapt to changes in regulation. This kind of friendly adaptive regulation may promote the Hong Kong model to become a model for the regulation and development of global virtual assets and Web 3.

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