Strong regulation is coming? Where will Hong Kong's cryptocurrency OTC go?

Since 2021, the Chinese government has explicitly banned cryptocurrency transactions. Since traditional financial institutions cannot directly participate in cryptocurrency transactions, over-the-counter (OTC) transactions have become the main channel for many Chinese investors to participate in the cryptocurrency market in order to circumvent regulatory restrictions and meet their investment needs.

OTC stands for Over-the-Counter. As the name suggests, any place where transactions are conducted outside of traditional exchanges can be considered an OTC market. In the field of cryptocurrency, OTC transactions are mainly conducted in three forms: online platforms using social media as a medium, offline physical exchange points, and crypto ATMs.

As an international financial center, Hong Kong's open attitude and policies towards cryptocurrencies have provided new channels for mainland Chinese investors. According to Chainlysis data, Hong Kong's cryptocurrency adoption rate has increased by 85.6% in the past year, making it the fastest growing region in the region. In order to further strengthen industry supervision and reduce retail investment risks, the Hong Kong Securities and Futures Commission announced in September that it plans to jointly supervise OTC virtual asset trading services with the Customs Department. Previously, in the proposal published in February 2024, this area was only supervised by the Customs. It is reported that the SFC has consulted the industry on a new licensing system for over-the-counter transactions of cryptocurrencies. In addition, the SFC is also exploring a licensing system for cryptocurrency custody services .

1. Current situation of OTC in Hong Kong

Hong Kong's cryptocurrency over-the-counter (OTC) market was once booming, with many exchange shops scattered around the streets, providing users with convenient cash and cryptocurrency exchange services. These shops usually do not require users to undergo identity verification (KYC), and the single transaction limit is also high. For example, last year some shops could exchange up to 1 million Hong Kong dollars in a single transaction, and users only needed to leave a phone number or email address to complete the transaction. Compared with the high handling fees of digital exchanges, the exchange rates of OTC exchange shops are more attractive and more convenient, attracting a large number of users.

According to the survey, as of June 2023, the total amount of digital assets flowing through Hong Kong reached US$64 billion, of which OTC exchange shops accounted for a considerable proportion. Hong Kong law enforcement agencies initially estimated that there are about 200 physical virtual asset OTC trading shops in Hong Kong, and about 250 active online virtual asset trading service providers.

However, this free trading environment also hides risks. The lack of regulation in the OTC market has given rise to illegal activities such as money laundering and fraud. For example, in the JPEX and Hounax incidents in 2023, some cryptocurrency exchange stores falsely advertised the compliance of the platform, causing investors to suffer heavy losses. In the JPEX incident, investors lost up to $180 million, and the Hounax scam caused 145 victims to lose a total of $18.9 million.

2. In February 2024, Hong Kong announced plans to bring virtual currency OTC exchanges under regulation

In response to the chaos in the OTC market, the Hong Kong government decided to strengthen supervision. In February 2024, Hong Kong Financial Services and Treasury Secretary Paul Chan said that the government plans to bring virtual currency OTC exchanges under supervision and consult on the proposed regulatory framework. According to legislative proposals, Hong Kong plans to establish a licensing system under the customs department, requiring all virtual asset OTC trading service providers to apply for a license and comply with relevant regulations such as the Anti-Money Laundering Ordinance. This means that the era of no KYC will come to an end, and OTC transactions will be more transparent and standardized.

By reviewing the legislative proposal, we can see that the main contents of the new regulations will include:

1) Licensing system:

• All online platforms and offline entities (including ATMs) engaged in virtual asset spot trading services in Hong Kong must apply for a license from the Hong Kong Customs.

• This move means that the era without KYC (identity authentication) has officially come to an end, and all OTC platforms must go through the KYC process.

2) Trading currency restrictions:

• Licensed OTC platforms are only allowed to offer cryptocurrencies listed on exchanges licensed by the Hong Kong Securities and Futures Commission, as well as stablecoins that will be licensed by the Hong Kong Monetary Authority in the future.

3) Anti-money laundering and terrorist financing compliance:

• Licensed OTC platforms must comply with the provisions of Hong Kong's Anti-Money Laundering Ordinance and establish a sound anti-money laundering and terrorist financing system, including collecting customer information and monitoring suspicious transactions.

4) Penalties for violations:

• Operating an OTC business without a licence is an offence and, upon conviction, is punishable by a maximum fine of HK$1 million and two years' imprisonment.

• If a licensed institution violates relevant regulations, it will face administrative penalties, including fines, reprimands, suspension or revocation of licenses, etc.

The Hong Kong government's public consultation on the OTC licensing system ended in April. The new rules have sparked heated discussions in the industry. Some believe that this will promote industry compliance, but others worry that overly strict regulation will hinder industry development. The specific implementation details of the new rules remain to be seen, but it is foreseeable that the Hong Kong OTC market will usher in major changes.

3. How will the new regulations affect the market?

The introduction of the new regulations will have a profound impact on the Hong Kong cryptocurrency market, especially the OTC trading sector. Specifically:

1. Industry reshuffle, head effect intensified: New regulations require OTC platforms to perform KYC certification, comply with anti-money laundering regulations, and limit tradable currencies, which will significantly increase operating costs. Small OTC exchange shops may be forced to exit the market due to their inability to bear compliance costs, while large, compliant platforms will gain a larger market share, and industry concentration will further increase.

2. Compliance costs rise, and transaction costs may be passed on: In order to meet regulatory requirements, OTC platforms need to invest more resources in compliance construction, such as hiring compliance personnel, upgrading KYC systems, etc. Part of these cost increases may be passed on to users, resulting in a decrease in the cost advantage of OTC transactions.

3. Decreased user trading experience: The introduction of KYC certification means that users need to provide more personal information, and the convenience of transactions will be reduced. In addition, the restriction on tradable currencies may also reduce the user's freedom of trading choice.

4. Improved market transparency and reduced risks: The implementation of the new regulations will make OTC transactions more transparent, and regulators will be able to better monitor capital flows and combat illegal activities such as money laundering. At the same time, the supervision of platforms will also raise industry barriers and reduce the risk of investors being defrauded.

Although the new regulations may have a certain impact on the market in the short term, in the long run, a sound regulatory system will enhance investor confidence, attract more institutional funds, and promote a healthier and more sustainable development of the Hong Kong cryptocurrency market.