OTC dream awakened? Hong Kong proposes new rules to curb crypto over-the-counter exchange

If you observe carefully, you can find that there are many cryptocurrency exchange stores scattered on the streets of Hong Kong.

In the store, users can freely exchange cash and cryptocurrencies without identity authentication KYC, that is, without asking any questions. According to field visits, a single exchange shop could exchange up to 1 million Hong Kong dollars at a time last year, and the exchanger only needs to reserve a phone number or email address. Compared with the high handling fees of Hong Kong digital exchanges, the exchange rate of money changers is undoubtedly more cost-effective and convenient. From a certain perspective, this reflects the characteristics of Hong Kong's financial freedom, but it has also caused some industry insiders to worry about anti-money laundering.

Just recently, the good times did not last long, and freedom was curbed. Hong Kong announced that it would issue new rules to stop over-the-counter (OTC) exchanges, and the above-mentioned companies are likely to face challenges of business restrictions or even liquidation due to the imminent supervision.

The concept of OTC is not unfamiliar to industry insiders. As the name suggests, any place that matches transactions independently outside of regular exchanges can be considered an over-the-counter exchange. Generally speaking, crypto OTC mainly covers three major carriers, namely online platforms based on social media matching, offline physical money changers, and crypto ATMs.

According to preliminary field observations by Hong Kong law enforcement agencies, there are about 200 physical virtual asset OTC shops (including OTC shops operated by ATMs) operating in Hong Kong, and about 250 online virtual asset trading service providers active. According to Chainalysis, money changers are an important part of OTC cryptocurrency trading, accounting for a major part of the $64 billion in digital assets flowing through Hong Kong as of June.

The main reasons for the regulation are the anti-money laundering defects of OTC itself, the disorder of market order and the lack of effective investor protection. In particular, in the JPEX and Hounax incidents that received a lot of attention last year, some cryptocurrency exchange shops became the driving force behind the incidents, and the false propaganda platform has obtained a compliance license. Data shows that in the JPEX incident, investors lost $180 million, and in the Hounax scam, 145 victims lost a total of $18.9 million. As of now, most investors' funds have not been recovered.

Against this backdrop, on February 2, 2024, Hong Kong Financial Services and the Treasury Secretary Paul Chan said that the government believes that it is necessary to bring virtual currency over-the-counter (OTC) exchanges under regulation, and will launch a consultation on the proposed regulatory framework in the near future, hoping that citizens and stakeholders will actively express their opinions. In the following days, on February 8, the Hong Kong government launched a public consultation on the legislative proposal to establish a licensing system for virtual asset over-the-counter (OTC) service providers, and the consultation period will end on April 12.

According to the legislative proposal, Hong Kong plans to establish a licensing system under the Customs Department. Anyone who engages in any virtual asset spot trading service in Hong Kong, including online platforms and offline entities including ATMs, must apply for a license from the Commissioner of Customs. Licensed virtual asset OTC operators must comply with the anti-money laundering and terrorist financing regulations and other regulatory requirements stipulated in the Anti-Money Laundering Ordinance. In short, cryptocurrency OTC providers need to collect customer records and increase personnel to monitor improper trading behavior, and the previous era of no KYC has officially come to an end.

Regulatory scope of virtual asset OTC trading business, source: JunHe

Secondly, the currencies that users can trade are also restricted. It is recommended that the services provided by virtual asset OTC licensees can only cover tokens traded by retail investors on at least one virtual asset trading platform licensed by the SFC, as well as stablecoins issued by issuers licensed by the Hong Kong Monetary Authority (HKMA) after the proposed stablecoin issuer licensing system is implemented.

The proposal also specifies penalties for violations of relevant regulations. Anyone who engages in regulated virtual asset over-the-counter trading services without a license may be fined $1 million and imprisoned for two years upon conviction through public prosecution. In addition, if a licensee engages in improper conduct (such as violating other regulatory requirements), he or she may be subject to administrative penalties, including temporary suspension or revocation of the license, reprimand, order to make corrections, and/or a fine (not exceeding $500,000).

Proposed offences and (maximum) penalties under the Virtual Asset OTC Consultation Paper, source: JunHe

From a macro perspective, with the introduction of over-the-counter trading of virtual assets into the regulatory framework, coupled with the existing VATP license, the securities-type virtual asset trading license system (No. 1 license upgrade), the license to provide advice on securities-type virtual assets (No. 4 license upgrade), the license to manage investment portfolios containing virtual assets (No. 9 license upgrade), the Securities and Futures Commission’s guidance on tokenized securities business, and the upcoming stablecoin issuer license system, it undoubtedly means that Hong Kong’s governance framework for the crypto field has gradually matured, forming a relatively complete regulatory mechanism with licenses as the focus, covering both on-site and off-site.

On the other hand, the application deadline for licensed physical exchanges is also approaching. According to the rulebook formulated by the Securities and Futures Commission in mid-2023, licensed exchanges must obtain or apply for a license before February 29.

But when we focus on individuals, considering the differences in the impact of regulations, different entities have different opinions.

Chengyi Ong, Asia-Pacific policy director at Chainalysis, which tracks digital asset transactions, said the OTC framework in the legislative proposal "will lead to the consolidation and reorganization of existing institutions, the head effect will be strengthened, and the frequency of use of OTC platforms as cryptocurrency entry points will be greatly reduced" because providers must manage crime, cybersecurity and other operational risks.

Jason Chan, a Hong Kong-based partner at Howse Williams, a law firm that specializes in financial regulatory advisory services, said the proposed legislation to include the Hong Kong Customs Department along with other agencies could give the public the impression that regulation is "too fragmented."

In response, a spokesperson for the Financial Services and Treasury Department said that given the business functions of the customs department, it is the most appropriate agency to regulate cryptocurrency over-the-counter service providers. The spokesperson added that the rulebook of the proposal provides the necessary risk control and maximum investor protection.

For exchange shops caught in the regulatory vortex, a sharp increase in compliance costs is an inevitable trend.

One Satoshi is one of the chain OTC companies in Hong Kong. According to its co-founder Roger Li, the company's business mainly serves retail investors, usually conducting small transactions of HK$10,000 or less.

Li said that while the company has already conducted certain anti-money laundering and KYC checks, new requirements related to compliance personnel and record keeping may increase costs. In this case, OTC companies "either have to stop cryptocurrency business or apply for new licenses," and he is currently waiting for clearer policy guidance.

This regulation does not affect the application for licenses of crypto exchanges. Currently, there are only two licensed digital asset exchanges in Hong Kong, namely HashKey Exchange and OSL Group. According to the official website, as of February 27, a total of 19 institutions including OKX, Bybit, Crypto.com and HKVAX associated with Binance have submitted license applications. It is interesting to note that HTX, under the guidance of Justin Sun, withdrew its application three days after submitting it, and did not disclose the reason for the withdrawal.

List of institutions that have applied for licenses, source: Hong Kong Securities Regulatory Commission official website

Looking at the world, although the United States has taken the lead, Hong Kong is still facing a battle for dominance in the crypto asset business with regions such as Singapore and Dubai. Therefore, Hong Kong has always adhered to inclusive and innovative policy formulation and has been at the forefront of policy formulation. Previously, the Hong Kong Securities and Futures Commission allowed exchange-traded funds to directly invest in cryptocurrencies; and before the Bitcoin spot ETF was passed in the United States, the Hong Kong Securities and Futures Commission had stated that it was "ready to accept the recognition application for virtual asset spot ETFs"; just a few days ago, the Hong Kong Monetary Authority announced that it was formulating rules for stablecoins.

From a regulatory perspective, most industry insiders believe that this move is not unforeseen. Vince Turcotte, a consultant to cryptocurrency exchanges, said: "Incorporating OTC trading into the regulatory structure is a natural extension of the system and can further legitimize the Hong Kong crypto market."

However, considering the numerous offshore cryptocurrency platforms around the world and the difficulty in tracking P2P transactions, it is not easy for Hong Kong to regulate the industry and OTC transactions in a procedural manner. Carlton Lai, head of blockchain research at Daiwa Capital Markets, said: "The decentralization of cryptocurrency poses a huge challenge to regulation, and users can easily access offshore cryptocurrency exchanges and applications, even when avoiding government supervision."

Indeed, Hong Kong’s cryptocurrency crime rate has tripled over the past three years, with nearly 4.4 billion yuan (about $611 million) involved in cryptocurrency cases recorded in 2023. The Hong Kong Securities and Futures Commission (SFC) recorded 1,397 and 2,336 cryptocurrency crime cases in 2021 and 2022, respectively.

This number rose to 3,415 in 2023. Of course, the increase in numbers also means that the popularity of encryption in Hong Kong is increasing from a certain perspective.

In the final analysis, for Hong Kong, the cryptocurrency boat is far from the time to cross the mountains. In addition to the public's cognitive bias and the regulatory framework that needs to be improved, the most important "capital flow" has just begun to take effect. But fortunately, every step of Hong Kong is still on the road, and with the current surge in mainstream currencies, Hong Kong's positioning as a wealth management center is also expected to bloom with new vitality.