OTC Awakening? Hong Kong Plans New Regulations to Curb Crypto Over-the-Counter Exchanges

Written by: Tuo Luo Finance

If you observe closely, you can find numerous cryptocurrency exchange shops scattered across the streets of Hong Kong.

In these shops, users can freely exchange cash and cryptocurrencies without identity verification KYC—meaning no questions are asked. According to on-site visits, a single exchange shop could exchange up to 1 million HKD at once last year, with the exchanger only needing to provide a phone number or email. Compared to the high fees of digital exchanges in Hong Kong, the rates at these exchange shops are undoubtedly more cost-effective and convenient. From a certain perspective, this reflects the characteristic of financial freedom in Hong Kong, but it has also raised concerns among some industry insiders regarding anti-money laundering.

Recently, however, this good situation has been curtailed. Hong Kong announced plans to introduce new rules to curb over-the-counter (OTC) exchanges, and the aforementioned companies are likely to face business restrictions or even challenges of being phased out due to imminent regulation.

The concept of OTC is not unfamiliar to industry insiders. As the name suggests, any venue that facilitates trading outside of conventional exchanges can be considered an over-the-counter trading venue. Generally, cryptocurrency OTC mainly encompasses three major platforms: online platforms primarily facilitated through social media, offline physical exchange shops, and cryptocurrency ATMs.

According to preliminary observations by Hong Kong law enforcement agencies, there are approximately 200 physical virtual asset OTC trading shops (including those operated by ATMs) operating across the city, as well as about 250 active online service providers offering virtual asset trading services. According to a Chainalysis survey, exchange shops are an important component of over-the-counter cryptocurrency trading, accounting for a significant portion of the 64 billion USD in digital assets flowing through Hong Kong as of June.

The main reasons for this regulatory response include the inherent anti-money laundering deficiencies of OTC, chaotic market order, and lack of effective investor protection, especially highlighted in last year's controversial JPEX and Hounax incidents, where some cryptocurrency exchange shops became key players, and platforms with false advertising obtained compliance licenses. Data shows that investors lost 180 million USD in the JPEX incident, while in the Hounax scam, 145 victims collectively lost 18.9 million USD, and to date, most investors have not recovered their funds.

Against this backdrop, on February 2, 2024, the Secretary for Financial Services and the Treasury of Hong Kong, Xu Zhengyu, stated that the government believes it is necessary to regulate virtual currency OTC exchanges and will soon consult on the proposed regulatory framework, hoping that citizens and stakeholders will actively express their opinions. In the following days, on February 8, the Hong Kong government began public consultations on the legislative proposal to establish a licensing system for virtual asset OTC service providers, with the consultation period ending on April 12.

According to the legislative proposal, Hong Kong plans to establish a licensing system under the customs department, including online platforms and offline entities such as ATMs. Anyone engaging in any virtual asset spot trading services in Hong Kong must apply for a license from the Customs Commissioner. Licensed virtual asset OTC operators must comply with the anti-money laundering and terrorist financing regulations set out in the Anti-Money Laundering Ordinance and other regulatory requirements. In short, cryptocurrency OTC providers will need to collect customer records and increase personnel to monitor improper trading activities, marking the official end of the no KYC era.

Regulatory scope of virtual asset OTC trading, Source: Junhe

Secondly, the types of cryptocurrencies that users can trade will also be restricted. The proposed services provided by licensed virtual asset OTC operators can only cover tokens that are available for retail investors to trade on at least one licensed virtual asset trading platform approved by the Securities and Futures Commission (SFC), as well as stablecoins issued by licensed issuers under the proposed stablecoin issuer licensing system after its implementation.

The proposal also clearly outlines penalties for violations of relevant regulations. Anyone who engages in regulated virtual asset OTC trading services without a license may face a fine of 1 million HKD and up to two years of imprisonment upon conviction through public prosecution. Additionally, licensed operators who engage in improper conduct (such as violating other regulatory requirements) may face administrative penalties, including temporary suspension or revocation of licenses, reprimands, orders to make corrections, and/or fines (not exceeding 500,000 HKD).

Proposed offenses and (maximum) penalties under the "Virtual Asset OTC Consultation Document," Source: Junhe

From a macro perspective, with the introduction of regulation for virtual asset OTC trading, along with existing VATP licenses, securities-type virtual asset trading license systems (License 1 upgrade), advisory licenses for securities-type virtual assets (License 4 upgrade), licenses for managing portfolios containing virtual assets (License 9 upgrade), SFC guidelines for tokenized securities business, and the upcoming stablecoin issuer licensing system, it undoubtedly signifies that Hong Kong's governance framework for the cryptocurrency sector is gradually maturing, forming a relatively comprehensive regulatory mechanism that encompasses both on-chain and off-chain through licensing.

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

However, concerning individuals, considering the varying impacts of regulations, different entities have differing opinions.

Chengyi Ong, the Asia-Pacific policy director at Chainalysis, which tracks digital asset trading, stated that since providers must manage crime, cybersecurity, and other operational risks, the OTC trading framework in the legislative proposal "will lead to the consolidation and restructuring of existing institutions, enhancing the head effect, while the frequency of using OTC platforms as entry points for cryptocurrencies will significantly decrease."

Jason Chan, a partner at Howse Williams law firm specializing in financial regulatory consulting in Hong Kong, noted that this legislative proposal includes the Hong Kong Customs Department along with other agencies, which may leave the public with the impression of "overly fragmented" regulation.

In response, a spokesperson for the Financial Services and Treasury Bureau stated that given the operational functions of customs itself, the customs department is the most suitable agency to regulate cryptocurrency OTC service providers. The spokesperson added that the rulebook of the proposal provides necessary risk controls and maximizes investor protection.

For exchange shops caught in the regulatory whirlpool, the sharp rise 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 primarily serves retail investors, usually conducting small transactions of 10,000 HKD or less.

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

This regulation does not affect the licensing of cryptocurrency exchanges. Currently, there are only two licensed digital asset exchanges in Hong Kong, namely HashKey Exchange and OSL Group. According to disclosures on their official websites, as of February 27, a total of 19 institutions, including OKX, Bybit, Crypto.com, and HKVAX associated with Binance, have submitted license applications. Interestingly, HTX, under the guidance of Sun Yuchen, withdrew its application three days after submission, without disclosing the reason for the withdrawal.

List of licensed institutions, Source: Hong Kong SFC official website

Globally, although the United States has taken the lead, Hong Kong still faces a battle for dominance in cryptocurrency business with regions like Singapore and Dubai, thus Hong Kong continues to adhere to a policy-making approach that balances inclusivity and innovation, staying at the forefront of policy direction. Previously, the Hong Kong SFC allowed exchange-traded funds to directly invest in cryptocurrencies; even before the approval of Bitcoin spot ETFs in the United States, the Hong Kong SFC had stated it was "ready to accept applications for the recognition of virtual asset spot ETFs"; just recently, the Hong Kong Monetary Authority announced that it is developing rules for stablecoins.

From a regulatory perspective, many industry insiders believe this move was not unforeseen. Cryptocurrency exchange consultant Vince Turcotte stated: "Incorporating OTC trading into the regulatory structure is a natural extension of the system and can further promote the legalization of Hong Kong's cryptocurrency market."

However, considering the numerous offshore cryptocurrency platforms and the difficulty in tracking P2P transactions globally, Hong Kong's process-oriented regulation of the industry and OTC trading is by no means an easy task. Carlton Lai, head of blockchain research at Daiwa Capital Markets, remarked: "The decentralization of cryptocurrencies poses significant challenges for regulation, as users can easily access offshore cryptocurrency exchanges and applications, even while avoiding government oversight."

The facts also reflect this, as the cryptocurrency crime rate in Hong Kong has doubled over the past three years, with recorded cryptocurrency cases in 2023 involving nearly 4.4 billion RMB (approximately 611 million USD). The Hong Kong Securities and Futures Commission (SFC) recorded 1,397 cryptocurrency crime cases in 2021 and 2,336 cases in 2022.

This number rose to 3,415 cases in 2023. Of course, the increase in numbers also indicates that the popularity of cryptocurrencies in Hong Kong is on the rise.

Ultimately, for Hong Kong, the journey of cryptocurrency is far from reaching the moment of crossing the mountains. Besides public perception biases and an incomplete regulatory framework, the most crucial "flow of funds" has only just begun to gain momentum. But fortunately, every step taken by Hong Kong is still on the path, and under the current surge of mainstream cryptocurrencies, Hong Kong's positioning as a wealth management center is also expected to bloom with new vitality.