In 2024, the international community will usher in a preliminary consensus on the regulation of digital finance. Digital finance, along with related blockchain technology, smart contracts, and distributed ledger technology (DLT), will form industry-wide universal rules. As the largest offshore RMB center and international financial center, the Hong Kong region has a unique advantage in developing financial technology and is one of the earliest regions to lay out the application of digital finance and blockchain technology.

With the continuous innovation of financial technology and the rapid development of blockchain technology, there have been multifaceted and multilevel connections between digital finance and traditional finance. In this context, it is urgent to introduce a regulatory system for digital finance and encrypted assets. As early as 2018, the Hong Kong region proposed a comprehensive investor protection policy for digital finance, making it one of the earliest regions to propose financial regulation in this field. In December 2023, it officially released the "Legislative Proposal Consultation Document for the Implementation of Stablecoin Issuers' Regulatory System in Hong Kong" and introduced the stablecoin issuer "sandbox" system in March 2024.

How should digital finance and encrypted assets be regulated? By whom? Which laws and systems apply? How to identify and regulate digital cross-border transactions? How to achieve investor protection? These are new issues in the context of blockchain technology, which have never been encountered in traditional financial regulation. It requires a balance between regulation and innovation. There is much discussion and significant differences in the international community, and sharp opposition has even arisen on some key issues. The U.S. House of Representatives voted in May of this year to pass the "Financial Innovation and Technology for the 21st Century Act" (referred to as the "FIT21" Act), which has become a reference for regulatory framework formulation in other parts of the world. This article, against the backdrop of the introduction of the "FIT21" Act, combined with the key points of the relevant regulatory framework already announced in the Hong Kong region, summarizes the connotations and classifications of encrypted assets, and summarizes the key points and main opposing viewpoints of the "FIT21" Act. It also puts forward some thoughts and prospects for the next regulatory details in the Hong Kong region.

Encrypted Assets and Stablecoins

Encrypted assets are a subset of digital assets. There is no unified definition of encrypted assets, and in some applications, they are also referred to as virtual assets, showing significant differences in structure, nature, and use. The scope of encrypted assets is very broad, including investment-related tokens, stablecoins, utility tokens, and non-fungible tokens.

The type of encrypted asset most directly linked to traditional finance is digital stablecoins. Digital stablecoins are generally anchored to fiat currencies or pegged to single or multiple assets. Due to the lack of a mature regulatory framework for digital stablecoins worldwide, the value support mechanism of individual stablecoins is not transparent in reality, and some stablecoins are not stable. Malicious incidents of stablecoin defaults have also occurred in the past, such as the collapse of the Terra Luna stablecoin in May 2022.

From the perspective of the operation mechanism of blockchain, digital stablecoins usually have three types: the first type is stablecoins backed by fiat currency (such as USDT issued by Tether and USDC issued by Circle), which are usually centralized and pegged to fiat currency, and can be exchanged 1:1 with fiat currency. The second type is stablecoins backed by cryptocurrencies (such as DAI issued by MakerDao). In this model, the reserve assets are held by smart contracts (Protocol), and they are mostly decentralized stablecoins, with the types and quantities of reserve assets being relatively transparent. Users can obtain digital stablecoins by depositing encrypted assets as collateral, and can also redeem digital collateral in reverse. Due to the significant value fluctuations of the collateral encrypted assets, in order to maintain the relatively stable price of stablecoins, users usually need to deposit collateral assets in excess of a 1:1 ratio. The third type is algorithm-based stablecoins (such as LUNA issued by Terra and FEI issued by Fei Labs). These stablecoins maintain their relationship with the anchored assets through complex blockchain algorithm rules and stability mechanisms, and usually do not have reserve assets corresponding to the value of stablecoins, so these stablecoins are often unstable. The legislative regulation of stablecoins is the most critical link in forming and improving the regulatory framework for digital finance. The stablecoin regulatory frameworks proposed by various governments mainly focus on the first two types mentioned above.

Digital Financial Regulation Framework in the Hong Kong SAR

The Hong Kong region is one of the earliest regions to lay out the blockchain encrypted asset industry. The Hong Kong Monetary Authority (HKMA) began researching Distributed Ledger Technology (DLT) as early as 2016 and first released a blockchain white paper. In 2019, the HKMA and the Central Bank of Thailand jointly conducted the "mCBDC Bridge Project" for "cross-border networks of multiple central bank digital currencies" to study the application of wholesale central bank digital currencies in cross-border payments. This project received strong support from the Innovation Hub of the Bank for International Settlements under the Hong Kong Center 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 HKMA announced the "Hong Kong Fintech 2025" strategy to promote the development of digital financial technology in Hong Kong.

Currently, the international market value of encrypted assets has shown significant growth, reflecting the increasingly close relationship between the encrypted asset industry and the mainstream financial system. On December 27, 2023, the HKMA launched a consultation on the legislative proposal for the implementation of the stablecoin issuer regulatory system and announced the introduction of a "sandbox" arrangement (Original text of the HKMA consultation proposal). This consultation document embodies a series of arrangements for regulating relevant institutions and activities based on the principle of "same risks, same regulation" with risk control as the basis. The proposed digital asset regulatory framework will focus on examining the impact in three aspects: (1) the stability of the Hong Kong SAR currency and financial system; (2) user and investor protection; (3) fraud and money laundering activities that may be involved in digital asset transactions. In terms of the specific implementation of the regulatory system, the current regulatory framework for encrypted assets will focus on three aspects: (1) the establishment of a regulatory system for "payment-purpose digital stablecoins"; (2) emphasis on investor protection in the encrypted asset industry; (3) regulation of registered institutions and their associated businesses and transactions to ensure the stability of the currency and banking system in the Hong Kong region. This regulatory consultation opinion and the "sandbox" arrangement have clearly put forward the views and operational guidelines of the Hong Kong SAR on financial technology, digital finance, and encrypted assets, and have promoted the formation of industry consensus and international standards. Given the recent passage of the U.S. "FIT21" Act in the House of Representatives, the Hong Kong SAR also needs to introduce its own regulatory details at a time when in-depth discussions on international rules are taking place.

Discussion of the U.S. "FIT21" Act

There is considerable controversy internationally over the regulation of encrypted assets, involving discussions on the attributes of digital assets, such as whether the attributes of digital assets are commodities or securities. Which asset types should be regulated by the Securities and Exchange Commission, and which categories should be regulated by the Commodity Futures Trading Commission, as well as the issue of cross-regulation 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" (FINANCIAL INNOVATION AND TECHNOLOGY FOR THE 21ST, referred to as the "FIT21" Act), with a vote of 279 in favor and 136 against (House vote results). This bill will amend existing U.S. securities and commodity regulations to promote the application of digital assets.

The "FIT21" Act has sparked widespread discussion internationally, formally pushing the regulatory issues of the encrypted asset industry into the legislative process and opening policy-level discussions on some highly controversial issues. Currently, the "FIT21" Act has not been formally passed and will be voted on in the Senate, and there is ongoing debate and significant controversy surrounding the bill. Firstly, the U.S. Securities and Exchange Commission (SEC) has expressed strong opposition to the "FIT21" Act, with SEC Chairman Gary Gensler issuing a statement (Original SEC statement), stating that the bill would harm investor protection and that new digital regulatory legislation is not very necessary. Secondly, U.S. President Joe Biden also does not support the current form of the legislation. Before the House vote, the White House issued an administrative policy statement (Original White House statement), expressing opposition to the passage of "FIT21.SAP," stating that the government is eager to work with Congress to ensure a comprehensive and balanced regulatory framework for digital assets based on the current system, but "FIT21" lacks sufficient protection for consumers and investors.

We have conducted a detailed study of the details of the "FIT21" Act and compiled mainstream viewpoints supporting or opposing the bill based on policy communications issued by different U.S. government agencies. The "FIT21" Act will provide a beneficial reference for the Hong Kong region's next steps in introducing its own regulatory details. In summary, the main points supporting "FIT21" are: (1) The "FIT21" Act clarifies the jurisdiction of the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC), avoiding the ambiguity and disputes in the regulatory boundaries of the two; (2) The bill fills the current regulatory gap in the digital commodity spot market; (3) The bill can promote innovation in the digital finance field because it clarifies the responsibilities and obligations of cryptocurrency intermediaries and entrepreneurs; (4) The bill specifies that cryptocurrency intermediaries should be subject to the Bank Secrecy Act, addressing anti-money laundering issues; (5) The bill protects the interests of investors, for example, by establishing operational rules for digital asset intermediaries, including prohibiting mixed-source funds and increasing disclosure requirements for digital assets.

At the same time, the main points opposing "FIT21" are: (1) The bill undermines existing securities laws because "FIT21" gives cryptocurrency companies and encrypted assets more lenient rules than traditional securities markets; (2) The bill does not adequately protect digital asset investors and the clients of digital asset companies; (3) The bill does not fully address illegal financing issues.

Due to the many differences between the encrypted asset industry and traditional finance, "FIT21" proposes regulatory details for new issues that would not arise in traditional finance and provides regulatory opinions on issues that are widely disputed internationally. Our summary of the key points and innovations of the "FIT21" Act is as follows. First, "FIT21" clarifies the regulatory framework for digital stablecoins, which is a beneficial reference for the upcoming "sandbox" system in the Hong Kong region. "FIT21" defines "stablecoins for payment purposes" as digital assets issued by issuers regulated by federal or state regulatory agencies and having the following characteristics: (1) used or designed for payment or settlement; (2) the issuer is obligated to redeem at a fixed currency value while maintaining the stable value of the digital asset (relative to a fixed amount of currency value); (3) does not include (a) the national currency or (b) securities issued by registered investment companies.

Second, the "FIT21" Act clarifies the distinction between "digital assets" and "digital commodities." The criteria for distinguishing the two are mainly: (1) the decentralization level and function of the underlying blockchain system of digital assets; (2) the method by which end users acquire digital assets; (3) the nature of the users holding digital assets. For example, if the issuance activity of digital assets is not for fundraising purposes, only involves nominal value exchanges of digital assets, and is equally open to all participants, or users acquire them through digital commodity exchanges, the digital assets are likely to meet the criteria for "digital commodities." For example, if the issuance of digital assets does not depend on a decentralized blockchain protocol and the issuance of digital assets has fundraising purposes, it is likely to be classified as "restricted digital assets."

In addition, "FIT21" creates a self-certification process for "digital commodities," under which anyone can submit evidence to the U.S. Securities and Exchange Commission (rather than the U.S. Commodity Futures Trading Commission) to prove that the blockchain involved in the digital assets is a decentralized system. Before assets on such systems are considered "digital commodities" under the jurisdiction of the U.S. Commodity Futures Trading Commission, the U.S. Securities and Exchange Commission will have 60 days to reject certification. According to this process, "restricted digital assets" can initially be issued as a security (subject to the disclosure and issuance requirements of the U.S. Securities and Exchange Commission, similar to traditional securities), and then can be transformed into "digital commodities" through the self-certification process. Currently, the regulatory principles for products such as Bitcoin and Ethereum spot ETFs issued in the Hong Kong region depend on the determination of whether such products belong to securities or commodities, and the division of corresponding regulatory procedures. The certification rules proposed by "FIT21" are an important reference for the listing and regulation of subsequent blockchain products in the Hong Kong region.

Third, "FIT21" for the first time clarifies the regulatory responsibilities of the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodity Futures Trading Commission (CFTC) for digital assets (previously, the two often "fought"), and requires the updating and supplementing of existing 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; and whether "stablecoins for payment purposes" should be under the jurisdiction of the SEC or the CFTC is determined based on the nature of the trading intermediary. Currently, the regulatory principles for products such as Bitcoin and Ethereum spot ETFs issued in the Hong Kong region depend on the determination of whether such products belong to securities or commodities, and the division of corresponding regulatory procedures. The operational rules proposed by "FIT21" are an important reference for the listing and regulation of subsequent blockchain products in the Hong Kong region.

Fourth, "FIT21" clarifies the definition of digital asset intermediaries and registration requirements. The bill requires digital asset intermediaries (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 types of digital assets they trade ("restricted digital assets" or "digital commodities"). This includes: (1) The SEC will oversee qualified digital asset custodians, digital asset brokers, digital asset dealers, and digital asset trading systems for "restricted digital assets"; (2) The CFTC will regulate qualified digital asset custodians for "digital commodities," digital commodity exchanges, digital commodity brokers, and digital commodity dealers; (3) The bill requires the SEC and CFTC to establish rules for dual registration of intermediaries and related institutions; (4) The bill specifies 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."

Reflection and Prospects

Currently, the development of blockchain technology has entered the fast lane, and the ecosystem has initially taken shape, gradually forming international consensus on rules. In the public blockchain sector, the world-class public chain "Conflux Network," developed with the participation of Chinese Academy of Sciences academician and Tsinghua University professor Andrew Yao, has attracted widespread attention internationally, with many Chinese and international web 3.0 companies laying out blockchain layer 2 networks and related applications on the Conflux public chain. As one of the earliest regions to implement digital finance, the Hong Kong region has attracted global attention for its market openness and inclusiveness, and the proactive measures of the Hong Kong Monetary Authority (HKMA) in proposing a digital financial regulatory framework have become a strong embodiment of the region's international competitiveness.

Regulation and innovation are a dynamic balance. It is widely recognized internationally that blockchain technology has a deep impact on the transformation of financial markets, but it is not certain whether all traditional financial services will be placed on the blockchain and achieved through smart contracts and distributed ledger technology (DLT), which still needs to be observed. This also means that the regulation of digital finance is a continuous process of updating and improvement, and international experience is an important reference.

The Hong Kong region has always adopted the concept of "same business, same regulation" and maintained a neutral attitude towards technology, which is the core regulatory thinking that allows innovation and regulation to achieve a healthy balance. For digital finance, the Hong Kong region has basically applied the same principles of regulating exchanges and brokers, and has imposed the same regulatory requirements on licensed institutions. With the U.S. "FIT21" Act officially entering the legislative process, the digital finance industry will quickly reach a universal consensus on core elements internationally, and the market will form clearer industry rules based on this consensus. It is necessary for the Hong Kong region to clearly define its regional regulatory details at the time when international rules are forming, creating a competitive ecosystem for digital finance and further consolidating its position as an international financial center.

[1] "Sandbox" is a newly emerging regulatory term in the financial technology field. The original meaning of "sandbox" is a place where children play with sand, allowing people to play and be creative in a limited and safe environment. In the financial technology field, "sandbox" mainly refers to regulatory agencies allowing financial institutions to test new services and products in a controlled and small-scale environment before launch, collect data and user feedback, and ensure that the services and products comply with regulatory requirements.

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