What are the risks of OTC trading in Hong Kong? How can retail investors protect themselves legally?
Written by: Mankun Blockchain Legal Services
According to the South China Morning Post, Hong Kong has seen the largest increase in cryptocurrency activity in East Asia this year. In the global cryptocurrency adoption index compiled by Chainanalysis, Hong Kong jumped from 47th place last year to 30th place this year. This indicates an upward trend in cryptocurrency trading in Hong Kong. In addition to centralized exchanges, many friends have expressed interest in virtual currency OTC trading in Hong Kong. So, what are the risks of OTC trading in Hong Kong? How can retail investors protect themselves legally? Today, Mankun Lawyers will explore this with you.
Retail Investors and Virtual Currency OTC Trading
1.1 Definition of Retail Investors and OTC Trading
Retail investors typically refer to those who trade virtual currencies primarily with small amounts of their own funds.
The Over-the-Counter (OTC) market, also known as the counter trading market, refers to trading that occurs directly outside of a centralized exchange.
Exchange trading (also known as on-exchange trading) is based on trust in the exchange; whereas OTC trading is based on mutual trust between the parties. Due to the inherent advantages of OTC trading, institutional investors or high-net-worth individuals may also choose to engage in OTC trading for large transactions.
On February 8, 2024, the Hong Kong government released a public consultation document titled "Legislative Proposals for Regulating Virtual Asset OTC Trading," which suggests defining "virtual asset OTC trading" as:
Providing virtual asset spot trading services in a business form, whether through physical stores (including ATMs) or other forms (such as internet platforms), and explicitly excluding trading platforms that have obtained VASP licenses.
Since "virtual asset OTC trading business" only includes services provided in a business form, transactions between individuals or other entities that are not for business purposes are not subject to licensing requirements. However, this does not mean that retail investors do not face other risks when trading virtual currencies through OTC.
1.2 Main Forms of Virtual Currency OTC Trading in Hong Kong
Virtual currency OTC trading in Hong Kong can generally be divided into two forms: online and offline.
Online: This refers to users directly buying and selling cryptocurrencies without the involvement of intermediaries. Generally, a platform acts as a matching intermediary, but the flow of funds and virtual currencies does not go through the platform, but rather through other payment channels. A typical example is OTC DEX, which is widely used on large trading platforms like OKEx.
Offline: This refers to face-to-face communication to complete transactions based on personal networks, such as the many virtual currency exchange shops and ATM exchange machines that used to be scattered on the streets of Hong Kong, providing convenient physical channels for virtual currency conversion.
According to rough estimates from initial observations by Hong Kong law enforcement agencies, there are about 200 physical virtual asset OTC trading shops (including those operating through ATMs) in operation across Hong Kong, as well as about 250 active online service providers offering virtual asset trading services.
Virtual currency OTC trading has advantages such as flexible transactions, reduced price slippage, and lower participation thresholds, making it relatively friendly for retail investors who are new to virtual currencies.
Main Risks for Retail Investors Participating in Virtual Currency OTC Trading
2.1 Overview of Risks in Virtual Currency OTC Trading
Although OTC trading offers benefits such as reduced price slippage and increased privacy, it also comes with significant trading risks, such as:
Legal and Criminal Risks: Retail investors in OTC trading, especially in cross-border transactions, may easily violate various regulations regarding civil, administrative, criminal, and tax matters in different jurisdictions, thus bearing legal responsibilities.
Data Leakage Risks: If OTC merchants fail to protect retail investors' personal data or suffer from hacking attacks, personal privacy information may be leaked.
Transaction Loss Risks: Due to non-compliance of OTC merchants, market volatility, price manipulation, or counterparty defaults, investors may incur financial losses.
Given the strict cryptocurrency regulations in mainland China, Hong Kong's OTC trading provides an important trading channel for mainland investors, making it particularly significant. Therefore, this article will highlight risks for retail investors by combining the legal provisions of both regions.
2.2 Legal and Criminal Risks
Although retail traders generally have a low frequency and small amount of funds for cashing out virtual currencies, they still face legal and criminal risks in practice. This is specifically reflected in:
Retail investors may be suspected of money laundering or operating illegal gambling, leading to account freezes due to receiving illicit funds. Unlike traditional centralized exchanges where both parties trade based on trust in the platform, OTC trading relies on the level of trust between the parties. Some OTC counterparties may exploit information asymmetry to set traps for inexperienced retail investors, tempting them to accept potentially more favorable prices, thus turning them into tools for transferring illicit funds. Additionally, some unscrupulous OTC merchants may themselves be involved in criminal activities, or some criminal groups may use OTC merchants for money laundering activities. Finally, the anti-money laundering (AML) and counter-terrorism financing (CTF) regulations in Hong Kong also require retail investors engaging in OTC trading to remain vigilant to avoid legal liabilities due to violations of relevant regulations.
Legal liabilities arising from violating foreign exchange management regulations when buying and selling foreign exchange. In Hong Kong OTC trading, the exchange between various fiat currencies and virtual currencies is very common. According to the "Regulations on Foreign Exchange Management of the People's Republic of China," privately buying and selling foreign exchange, disguised foreign exchange trading, or illegally introducing large amounts of foreign exchange trading may result in warnings, confiscation of illegal gains, and fines from foreign exchange management authorities; if a crime is constituted, criminal responsibility will be pursued according to law. If retail investors use virtual currencies as a medium to earn profits from exchange rate differences by providing cross-border exchange and payment services, this constitutes disguised foreign exchange trading, which often leads to criminal liability for illegal business operations.
Fines or imprisonment due to violations of Hong Kong tax laws. Is tax required for virtual currency OTC trading in Hong Kong? According to the Hong Kong Inland Revenue Department's "Interpretation and Practice Notes No. 39" (DIPN39), the term "cryptocurrency business" includes the following common business activities:
(a) Trading of cryptocurrency
(b) Exchange of cryptocurrency
(c) Mining of cryptocurrency
DIPN39 states that profits sourced from cryptocurrency business activities conducted in Hong Kong are chargeable to profits tax.
Hong Kong adopts a territorial source tax system, meaning that only profits generated or sourced from Hong Kong are taxed. Non-Hong Kong residents engaging in business activities in Hong Kong must pay taxes on their Hong Kong-sourced profits, while profits sourced from outside Hong Kong, even if the business operates in Hong Kong, are not subject to tax. So, what is the profits tax rate in Hong Kong? According to Deloitte's "2024 Hong Kong Tax and Investment Guide," Hong Kong implements a two-tier profits tax rate:
For unincorporated businesses (such as sole proprietorships or partnerships), the tax rate for the first HK$2 million of assessable profits is 7.5%,
The rate for profits exceeding HK$2 million is 15%.
What are the penalties for failing to pay taxes on time?
Failing to pay the required taxes on time may result in the following consequences:
A fixed fine of HK$10,000,
A fine amounting to up to three times the underpaid tax,
In severe cases, a maximum imprisonment of three years (according to the Hong Kong Inland Revenue Department's "Penalty Policy").
Of course, if retail investors' virtual currency trading in Hong Kong is occasional and involves small amounts, such behavior is unlikely to be considered "business" under Hong Kong law, thus not subject to tax review by relevant authorities. However, for investors engaging in frequent and large transactions, it is essential to pay special attention to relevant tax requirements. Additionally, future regulatory frameworks may change, which is worth monitoring closely.
2.3 Data Leakage Risks
The technical complexity of the fund settlement and currency transfer process in OTC trading increases the difficulty of ensuring data security. Large-scale virtual currency OTC trading requires handling significant amounts of funds and digital asset transfers, which may lead to technical failures and management challenges. For example, technical issues may include blockchain network problems, wallet security, transaction confirmation delays, and the reliability of infrastructure used for digital asset transfers. Administrative issues may involve relevant processes and procedures for transactions, such as identity verification, terms negotiation, legal document execution, and transaction record management.
Some OTC merchants have not implemented effective personal information protection measures, resulting in security vulnerabilities on their platforms. Third-party platforms may also have security vulnerabilities. Third-party platforms that facilitate OTC virtual currency trading may be susceptible to security breaches and information leaks. This could lead to unauthorized access to sensitive data such as traders' identities, transaction details, and other proprietary information. Cybersecurity threats such as phishing attacks and malware may exploit these vulnerabilities, jeopardizing the integrity of the platform and the security of user assets.
Even well-known exchanges like Huobi faced information leakage risks disclosed by white hats in 2021, involving a wide range of OTC trading information, large account information, customer information, internal technical architecture, etc. Although Huobi responded that no actual leak occurred and only white hats downloaded some data, it is enough to sound the alarm for every retail investor engaging in OTC trading. Additionally, some criminal groups may exploit OTC platforms to steal user information, and some unscrupulous OTC platforms may even sell user information externally, which is enough to raise alarms for every retail investor.
2.4 Transaction Loss Risks
In virtual currency OTC trading, the risk of transaction losses is particularly critical. Compared to centralized exchanges, OTC trading requires a higher level of trust between the parties involved. Any party may default, delay performance, or fail to perform completely, and due to information asymmetry and communication barriers, trust risks may be exacerbated, leading to transaction breakdowns and even a collapse of trust. Once the foundation of trust is lost, it can have significant negative impacts on future cooperation between the parties and even the entire market environment.
Fraud is one of the main risks in the OTC market, especially in cases involving large sums of money or cross-border transactions. For example, a counterparty may fabricate their identity, falsely claim or exaggerate their ability to deliver virtual assets, and use deceptive means to sign or fabricate transaction terms. A common scam is fraudulent refunds, where one party cancels payment after receiving digital assets.
Fraud or bankruptcy of the transaction facilitator may lead to related losses. In OTC trading, if the party responsible for facilitating the transaction commits fraud or goes bankrupt, it may result in losses for other parties involved. Since trust is a key component of OTC trading, any failure on the part of the facilitator can create a chain reaction, damaging the assets of all participants in the transaction.
In cross-border transactions, especially between mainland China and Hong Kong, transaction risks become more pronounced due to differences in legal systems, regulatory frameworks, and enforcement capabilities, which increase the complexity of transactions. Jurisdictional issues may make it difficult to seek legal remedies in the event of a default or fraud by one party. Additionally, language barriers, differing document standards, and conflicts in legal interpretations may increase the likelihood of misunderstandings or other disputes.
How Can Retail Investors Protect Themselves and Achieve Compliant Trading?
3.1 How to Address Criminal Violation Risks?
Enhance Compliance Awareness: Virtual currency OTC traders should stay informed about the latest regulatory developments, especially regarding anti-money laundering (AML), counter-terrorism financing (CTF), and tax compliance requirements.
Avoid Participation in Suspicious Transactions: Do not purchase virtual currencies from unknown sources to avoid becoming part of the chain of illegal funds; also, keep records of all transaction details to prove the legal source of funds to regulatory authorities if needed.
Seek Professional Support: Find professional lawyers familiar with virtual currency trading and related laws to provide comprehensive support for businesses regarding license applications, compliance agreement drafting, and dispute resolution.
3.2 How to Address Data Leakage Risks?
Due Diligence: Conducting thorough due diligence is crucial. This includes verifying the identity of the counterparty, assessing their financial stability, and reviewing their transaction history. Tools such as Know Your Customer (KYC) procedures and background checks can provide effective information.
Be Cautious When Submitting Personal Information: Only provide personal identification information (such as KYC) to trading platforms when necessary, and avoid disclosing sensitive information to third parties.
Pay Attention to Cybersecurity: Access trading accounts only through trusted devices (such as personal computers or smartphones), avoid using public Wi-Fi, and set complex passwords for accounts, changing them regularly.
3.3 How to Address Transaction Loss Risks?
To mitigate transaction loss risks, traders should strengthen their technical protection measures. For example:
Secure Fund Storage: Multi-signature wallets and cold storage (offline wallets not connected to the internet) are crucial for protecting large holdings. These technologies reduce the risk of unauthorized access and hacking attacks.
Use Third-Party Custodial Services: Reliable third-party custodial services can act as intermediaries, holding funds or assets until both parties fulfill their obligations. Custodial arrangements can minimize the risk of one party defaulting, especially in large transactions.
Clearly Define Contract Terms: Clearly drafted contracts can specify delivery schedules, payment methods, and dispute resolution mechanisms, reducing ambiguity. For instance, jurisdiction clauses can allow both parties to resolve disputes according to the agreed-upon dispute resolution location and applicable law in the event of a conflict.
Through these measures, virtual currency traders can effectively reduce the three major risks of criminal violations, data leakage, and transaction losses, protecting their interests. Although these measures are relatively effective, no strategy can completely eliminate these risks due to the inherent decentralized and global nature of OTC trading. Retail investors must remain vigilant, take proactive actions, and be prepared to address potential disputes to protect their assets and interests.
Conclusion
The virtual currency market in Hong Kong offers retail investors abundant opportunities but also comes with complex risks and challenges. From legal violations and data leaks to transaction losses, each risk poses a threat to investors' personal safety, property, and information. Therefore, retail investors must be well-prepared before entering this market, not only by understanding relevant laws and regulations but also by mastering the basics of virtual currency trading.
Compliance operations, enhanced security awareness, and rational investment are key for retail investors to address risks. Additionally, understanding local laws and regulations and seeking support from professional advisors can effectively safeguard their rights in a complex market environment. Only by maintaining a cautious attitude can retail investors achieve long-term growth and surf the virtual currency market with peace of mind.
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