Written by: Liu Honglin

Hong Kong takes two-pronged approach to virtual currency regulation

On February 2, 2024, Hong Kong Financial Services and the Treasury Bureau Director 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 short term, hoping that citizens and stakeholders will actively express their opinions.

We are not sure how short this short period will be, but one thing is certain: virtual currency OTC will usher in a compliance era in Hong Kong.

As an established international financial center, Hong Kong has always been relatively open and tolerant to the new thing of virtual currency. Hong Kong does not regard virtual currency as legal tender or financial instruments, but defines it as a kind of “virtual asset” and takes corresponding regulatory measures according to the activities involved and the degree of risk.

At present, Hong Kong’s regulation of virtual currencies mainly focuses on two aspects: one is the regulation of virtual asset trading platforms (VASPs), and the other is the regulation of over-the-counter (OTC) merchants.

According to the “Licensing System for Providing Virtual Asset Trading Services under the Securities and Futures Ordinance” issued by the Hong Kong Securities and Futures Commission (SFC) in June 2023, all platforms that provide virtual asset trading services in Hong Kong need to apply for a license from the SFC and comply with relevant laws, regulations and regulatory requirements. Currently, there are two licensed virtual asset trading platforms in Hong Kong (HashKey and OSL) that can provide Bitcoin (BTC) and Ethereum (ETH) trading services to retail investors through license upgrades. In addition, there are many platforms that are applying for licenses or are in the transition period. The SFC stated that it will review and improve the licensing system from time to time according to market conditions and investor protection needs.

Previously, Mankiw lawyers have written many articles to share with everyone related to Hong Kong’s licensed trading supervision, including “One Article Explains the Licensing System for Virtual Currency Exchanges in Hong Kong” and “One Article Explains How Can Virtual Currency Funds Conduct Business in Compliance in Hong Kong?” In this article, we will mainly talk about the supervision of virtual currency OTC merchants.

How many virtual currency OTC merchants are there in Hong Kong?

Virtual currency OTC merchants are institutions or individuals that provide over-the-counter (OTC) services. OTC trading refers to the purchase and sale of cryptocurrencies on platforms or channels other than exchanges, usually involving cash or other legal currencies. OTC trading has the following forms:

• Online platform: connects buyers and sellers through websites, social media, chat software and other online tools, and provides matching, custody, clearing and other services.

• Offline stores: Services that provide cash-for-cryptocurrency or vice versa in physical stores, usually without the need for real-name authentication or other compliance requirements.

• ATM: An automated teller machine located in a public place that allows the purchase or sale of cryptocurrencies using cash or bank cards.

According to rough estimates based on preliminary field observations by Hong Kong law enforcement agencies, there are approximately 200 physical virtual asset OTC trading shops (including OTC trading shops operated by ATMs) operating in Hong Kong, and approximately 250 active online virtual asset trading service providers.

In most offline stores and ATMs of OTC merchants, KYC is generally not required and transactions only take a few minutes to complete. This provides cryptocurrency users with a convenient, flexible and private transaction method, which is especially popular among mainland users.

Why do you say that? Although China explicitly prohibits virtual currency exchanges from operating in China, the amazing thing is that according to Chainalysis data, mainland China is still the fourth largest cryptocurrency trading market in the world. However, due to mainland policies, bank cards are increasingly frozen due to buying and selling virtual currencies, so more and more old players in the cryptocurrency circle choose to deposit and withdraw money at OTC merchants when traveling to Hong Kong.

Why is OTC regulation necessary?

Everything has two sides. While OTC merchants provide users with convenient and private deposit and withdrawal channels, they are also abused by criminals. On September 5, 2023, the Hong Kong police arrested 6 men involved in the JPEX case. One of the people involved was Chen Xiaolong, CEO of Crypto Leopard, a virtual currency OTC service provider.

The suspect in the JPEX case was arrested by the Hong Kong police. Image source: Techub News

In general, there are three problems with virtual currency OTC at present.

• Lack of effective supervision: Currently, Hong Kong has no clear regulatory framework and requirements for virtual currency OTC merchants, which has led to some irregular and illegal behaviors. For example, some OTC merchants are suspected of fraud, money laundering, terrorist financing and other criminal activities, which have harmed the interests of investors and social order. Some fraud gangs attract funds from retail investors through affiliated OTC trading shops.

• Lack of industry standards: Currently, OTC merchants in Hong Kong do not have unified industry standards and self-discipline mechanisms, and each operates independently, leading to market chaos and unfair competition. For example, in order to attract customers, some OTC merchants offer high returns, low fees, unlimited quotas and other conditions to induce users to make irrational transactions. In addition, some OTC merchants also have problems such as opaque information and poor service quality, which affect the credibility and efficiency of the market.

• Lack of user protection: Currently, OTC merchants in Hong Kong do not provide users with adequate protection measures and relief channels, and users often cannot get timely and effective solutions when they encounter problems. For example, some OTC merchants do not conduct identity verification and risk warnings for users, nor do they establish a complete complaint handling and dispute resolution mechanism. Users find it difficult to pursue responsibility or claim compensation when they encounter fraud, delays, errors, etc. In addition, some OTC merchants do not fully protect user privacy and data, resulting in user information leakage or abuse.

How does Hong Kong regulate virtual currency OTC?

On February 8, 2024, 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. By reviewing the legislative proposal, we have sorted out the relevant key issues for everyone.

1. Which OTC businesses will be regulated?

(1) According to the legislative proposal, all virtual asset over-the-counter trading services, whether through offline physical stores (including ATMs) or online website services, need to be regulated.

(2) The types of virtual assets available for trading by customers may include tokens traded by retail investors on at least one virtual asset trading platform licensed by the SFC, and stablecoins issued by issuers licensed by the Hong Kong Monetary Authority (HKMA) after the proposed licensing regime for stablecoin issuers is implemented.

(3) Based on the principle of “same business, same risks, same rules”, licensees must apply for a money service operator license if they provide legal currency remittance services. Licensed operators are not allowed to provide other services, including any form of virtual asset advisory or referral services, the provision of virtual asset derivatives or other financial products (including but not limited to pledge, lending and margin trading).

2. What are the conditions for applying for an OTC license?

(1) To ensure that a licence applicant has adequate local links to facilitate effective supervision and monitoring by the authorities, the applicant must be (i) a company established in Hong Kong with a fixed place of business, or (ii) a company established elsewhere and registered in Hong Kong under the Companies Ordinance.

(2) If the OTC service provider operates in the form of a physical store, the applicant must provide a suitable operating location. If the service is provided online, the applicant must provide information such as the office address and mailing address of the local management personnel, as well as the location where the local books and records are stored.

3. Which agency is responsible for compliance licenses?

(1) Any person who engages in any business related to virtual asset spot trading services in Hong Kong must apply for a licence from the Commissioner of Customs and Excise and must meet the fit and proper criteria and other factors that the Commissioner of Customs and Excise considers relevant. Licensed virtual asset OTC trading operators must comply with the anti-money laundering and terrorist financing requirements and other regulatory requirements set out in the Anti-Money Laundering Ordinance.

(2) Wallet registration system: Licensees must apply to the Commissioner of Customs and Excise to register all wallets used in their operations and ensure that the wallet list is constantly updated. To mitigate the risks of money laundering and terrorist financing, licensees will only be allowed to transfer such virtual assets from their registered wallets to wallets for which customers can provide proof of ownership and/or control.

(3) Licence is limited in time: A successful applicant will be issued with a licence for a period of two years and may apply for renewal for a further two years if the Commissioner of Customs and Excise is satisfied.

4. What is the cost of breaking the law?

(1) Any person who engages in regulated over-the-counter trading services for virtual assets without holding a licence is liable, upon conviction upon indictment, to a fine of HK$1 million and to imprisonment for two years.

(2) Any person who knowingly issues an advertisement regarding the provision of over-the-counter trading services for virtual assets by an unlicensed person commits an offence and is liable to a fine at level 5 (currently $50,000) and imprisonment for six months.

(3) If a licensee violates the statutory anti-money laundering and anti-terrorist financing provisions, upon conviction through public prosecution, he may be fined HK$1 million and imprisoned for two years. In addition, if a licensee engages in misconduct (such as violating other regulatory requirements), he may be subject to administrative penalties, including suspension or revocation of the license, reprimand, order to make corrections, and/or a fine (not exceeding HK$500,000).

(4) Offences related to fraudulent and misleading activities under the current Anti-Money Laundering Ordinance will apply to licensed virtual asset OTC traders. Any person who commits fraudulent or deceptive conduct in a transaction involving virtual assets shall be guilty of an offence and liable to a fine of $10 million and imprisonment for ten years. In addition, any person who makes a fraudulent or reckless misrepresentation to induce another person to engage in a transaction involving virtual assets shall also be guilty of an offence and liable to a fine of $1 million and imprisonment for seven years.

Conclusion

As an innovative financial instrument, Hong Kong’s regulation of virtual currency is to find the best solution between balancing market development and investor protection. By establishing a reasonable and effective regulatory framework, Hong Kong can promote the healthy development of the virtual currency industry while protecting the public interest and financial stability.

The legislative proposal on virtual currency OTC in Hong Kong is just the beginning of compliance supervision. For practitioners in the cryptocurrency circle, it seems that the policy has been tightened, but in fact it makes the rules of the game clearer. After all, the healthy development of an industry cannot always stay in a dark corner. Only when the sun shines in can everything be more brilliant.

Sources: Binance