According to the South China Morning Post, Hong Kong has seen the largest increase in cryptocurrency activity in East Asia this year. In this year's Global Cryptocurrency Adoption Index compiled by Chainanalysis, Hong Kong has jumped from 47th last year to 30th. This shows that cryptocurrency trading in Hong Kong is on the rise. In addition to centralized exchanges, many friends have expressed their 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 at the legal level? Today, attorney Mankiw will take you to find out.
Retail investors and virtual currency OTC transactions
1.1 Definition of Retail Investors and Over-the-Counter (OTC) Trading
Retail investors usually refer to investors who mainly trade virtual currencies with a small amount of their own funds.
The over-the-counter market, also known as the counter market, refers to transactions that are conducted directly outside the exchange instead of through a central exchange.
Exchange trading (also known as on-site trading) is based on trust in the exchange, while over-the-counter trading is based on mutual trust. Because of the inherent advantages of OTC trading, institutional investors or high-net-worth individuals who trade in large quantities sometimes choose over-the-counter trading.
On February 8, 2024, the Hong Kong government released a public consultation document on “Legislative Proposals for Regulating Over-the-Counter Transactions of Virtual Assets”, which proposed to define “Over-the-Counter Transactions of Virtual Assets” as:
Providing virtual asset spot trading services in the form of a business , whether through physical stores (including ATMs) or other forms (such as Internet platforms), and explicitly excluding trading platforms that have obtained VASP licenses.
Given that "over-the-counter virtual asset trading business" only includes services provided in the form of business, the sale of virtual assets between individuals and individuals or other entities that are not conducted for business purposes is not subject to licensing requirements. However, this does not mean that there are no other risks for retail investors to trade virtual currencies through OTC.
1.2 Main forms of virtual currency OTC transactions in Hong Kong
Hong Kong virtual currency OTC transactions can generally be divided into two forms: online and offline.
Online: refers to the direct buying and selling of cryptocurrencies between users without the involvement of intermediaries. Generally, the platform acts as a matchmaking medium, but the circulation and transaction of funds and virtual currencies are not carried out through the platform, but through other payment channels. A typical example is OTC DEX, which is widely used on large trading platforms such as Ouyi.
Offline: refers to completing transactions through face-to-face communication based on personal networks and other channels. For example, there were many virtual currency exchange shops and ATM machines scattered on the streets of Hong Kong, providing convenient physical channels for the conversion of virtual currencies.
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.
OTC transactions of virtual currencies have the advantages of flexible transactions, reduced price slippage, and low participation thresholds, making them relatively friendly to retail investors who are just getting started with virtual currencies.
The main risks of retail investors participating in virtual currency OTC transactions
2.1 Overview of Risks of Cryptocurrency OTC Transactions
Although OTC trading provides benefits such as reduced price slippage and improved privacy, it also has trading risks that cannot be ignored, such as:
1. Risk of illegal crimes : Retail investors in OTC transactions, especially cross-border transactions, can easily be held legally liable for violating various civil, administrative, criminal, and tax regulations in various jurisdictions.
2. Data leakage risk : Personal privacy information may be leaked due to OTC merchants’ failure to protect retail investors’ personal data or due to hacker attacks.
3. Risk of transaction loss : Financial loss due to non-compliance of OTC merchants, market fluctuations, price manipulation or counterparty default.
Due to the strict regulation of cryptocurrency in the mainland, Hong Kong OTC transactions provide an important trading channel for mainland investors and are of particular significance. Therefore, this article will combine the legal provisions of the two places to remind retail investors of the risks.
2.2 Risk of illegal and criminal activities
Although retail traders generally have a low frequency of cashing out virtual currency and a small amount of funds, in practice, retail traders still face the risk of illegal crimes. Specifically, they:
1. Retail investors are suspected of money laundering or opening casinos and other related crimes, and their accounts are frozen due to the illegal proceeds . Compared with traditional centralized exchanges, where both parties conduct transactions based on trust in the platform, OTC transactions rely on the degree of trust between the two parties. Some OTC counterparties will take advantage of information asymmetry and set traps for inexperienced retail investors, tempting them to accept potentially more favorable prices, thereby turning retail investors into tools for transferring stolen money. In addition, some bad OTC merchants themselves are involved in criminal activities, or some criminal gangs use OTC merchants to conduct money laundering activities. Finally, the anti-money laundering (AML) and counter-terrorism financing (CTF) regulations in Hong Kong also require retail investors who conduct OTC in Hong Kong to be vigilant and avoid legal liability for violating relevant regulations.
2. Bear legal responsibility for buying and selling foreign exchange in violation of foreign exchange management regulations. In Hong Kong OTC transactions, the exchange between legal currencies of various countries and virtual currencies is very common. According to the "Foreign Exchange Management Regulations of the People's Republic of China", those who buy and sell foreign exchange privately, buy and sell foreign exchange in disguised form, buy and sell foreign exchange, or illegally introduce large amounts of foreign exchange will be warned by the foreign exchange management authorities, and the illegal gains will be confiscated and fined; if it constitutes a crime, criminal liability will be pursued in accordance with the law. If retail investors use virtual currency as a medium to earn exchange rate differences by providing cross-border exchange and payment services, they are using the special properties of virtual currency to circumvent national foreign exchange supervision and realize the value conversion of foreign exchange and RMB through the exchange of "foreign exchange-virtual currency-RMB". This is a disguised sale of foreign exchange, and they are often held criminally liable for illegal business operations.
3. Fines or imprisonment for violating Hong Kong tax laws. Do you need to pay taxes for virtual currency OTC transactions in Hong Kong? According to Article 47 of the Hong Kong Inland Revenue Department's "Interpretation and Implementation Guidelines 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 Hong Kong sourced profits from cryptocurrency business activities are chargeable to profits tax.
Hong Kong adopts a territorial source tax system, which means that only profits generated in or derived from Hong Kong are taxed. Non-Hong Kong residents who engage in business activities in Hong Kong are subject to tax on their Hong Kong-source profits, while profits derived from outside Hong Kong are not subject to tax even if their business is operated in Hong Kong. So, what is the profit tax rate in Hong Kong? According to the "Hong Kong Tax and Investment Guide 2024" released by Deloitte, Hong Kong implements a two-tier profit tax rate:
For unincorporated businesses (such as sole proprietorships or partnerships), the first HK$2 million of assessable profits is taxed at 7.5%.
The tax rate for the portion exceeding HK$2 million is 15%.
What are the penalties for not paying taxes on time?
Failure to pay required taxes on time may result in the following consequences:
Fixed fine of HK$10,000,
Penalties of up to three times the amount of tax underpaid,
In serious cases , a maximum sentence of three years’ imprisonment may be imposed (according to the Hong Kong Inland Revenue Department’s Penalty Policy).
Of course, if retail investors’ virtual currency transactions in Hong Kong are occasional and small in amount, such behavior is unlikely to be considered as “business” under Hong Kong law and thus be audited and taxed by the relevant competent authorities. However, for investors who conduct regular and large transactions, they need to pay special attention to the relevant tax requirements. In addition, the regulatory framework may also change in the future, which deserves our close attention.
2.3 Data Leakage Risk
1. In OTC transactions, the technical complexity of the fund clearing and currency transfer process increases the difficulty of data security protection. Large-scale virtual currency OTC transactions need to handle the transfer of large amounts of funds and digital assets, which may lead to technical failures and management challenges. For example, technical issues include blockchain network problems, wallet security, transaction confirmation delays, and infrastructure reliability issues for digital asset transfers. Administrative issues may involve transaction-related processes and procedures, such as identity verification, terms negotiation, legal document execution, and transaction record management.
2. Some OTC merchants have not taken effective measures to protect personal information, resulting in security vulnerabilities on the platform. Third-party platforms may have security vulnerabilities. Third-party platforms that facilitate OTC virtual currency transactions may be vulnerable to security vulnerabilities and information leaks. This may lead to unauthorized access to sensitive data such as trader identities, transaction details and other proprietary information. Cybersecurity threats such as phishing attacks and malware may exploit these vulnerabilities and jeopardize the integrity of the platform and the security of user assets.
3. Even a well-known exchange like Huobi was disclosed by white hats in 2021 for information leakage risks, involving a wide range of OTC transaction information, large-scale information, customer information, internal technical architecture, etc. Although Huobi responded that no actual leakage occurred and only white hats downloaded part of the data, it was enough to sound the alarm for every retail investor who traded through OTC. In addition, some criminal gangs will use OTC platforms to steal user information, and some unscrupulous OTC platforms will even resell user information to the outside world, which is enough to sound the alarm for every retail investor.
2.4 Risk of Transaction Losses
1. In virtual currency OTC transactions, the risk of transaction loss is particularly critical. Compared with centralized exchanges, OTC transactions place higher demands on the trust between the two parties to the transaction. Because either party may breach the contract, delay performance, or perform incompletely, etc., and the two parties to the transaction may increase the trust risk due to information asymmetry and communication barriers, leading to the breakdown of the transaction and even the collapse of trust. Once the foundation of trust no longer exists, it will have a great negative impact on the future cooperation of the transaction parties and even the entire market environment.
2. Fraud is one of the main risks in the OTC market, especially when large amounts of money or cross-border transactions are involved. For example, the counterparty may fabricate their identity, lie or exaggerate their ability to deliver virtual assets, and sign or fabricate transaction terms through deception. A common scam is fraudulent refunds, where one party cancels payment after receiving digital assets.
3. Fraud or bankruptcy of the transaction matchmaker may lead to related losses. In OTC transactions, if the party responsible for matching the transaction commits fraud or goes bankrupt, it may cause related losses to other transaction parties. Since trust is a key component of OTC transactions, any failure of the matchmaker may have a chain reaction and cause damage to the property of all transaction participants.
4. In cross-border transactions, especially those between the mainland and Hong Kong, transaction risks become more prominent because differences in legal systems, regulatory frameworks, and enforcement capabilities increase the complexity of transactions. Jurisdiction issues may make it difficult to seek legal remedies when one party breaches a contract or commits fraud. In addition, factors such as language barriers, different documentation standards, and conflicts in legal interpretation may increase the likelihood of misunderstandings or other disputes.
How can retail investors protect themselves and achieve compliant trading?
3.1 How to deal with the risk of criminal violations?
1. Enhance compliance awareness : Virtual currency OTC traders should always pay attention to the latest regulatory developments, especially anti-money laundering (AML), counter-terrorist financing (CTF) and tax compliance requirements.
2. Avoid participating in suspicious transactions : Do not purchase virtual currencies of unknown origin to avoid becoming part of the circulation chain of illegal funds; at the same time, be sure to record all transaction details so that you can prove the legal source of funds to the regulatory authorities when necessary.
3. Seek professional support : Find professional lawyers who are familiar with virtual currency transactions and related laws to provide comprehensive support to companies regarding license applications, drafting of compliance agreements, and dispute resolution.
3.2 How to deal with the risk of data leakage?
1. Due diligence: It is critical to conduct thorough due diligence. This includes verifying the identity of the counterparty, assessing its financial stability, and reviewing its transaction history. Tools such as Know Your Customer (KYC) procedures and background checks can provide effective information.
2. Submit personal information with caution: Provide personal identification information (such as KYC) to the trading platform only when necessary, and avoid disclosing sensitive information to third parties.
3. Pay attention to network security: access your trading account only through trusted devices (such as personal computers or mobile phones), avoid using public Wi-Fi, and set complex passwords for your accounts and change them regularly.
3.3 How to deal with the risk of trading losses?
In order to cope with the risk of trading losses, traders should strengthen their technical protection measures. For example:
1. Safely store funds: Multisig wallets and cold storage (offline wallets that are not connected to the Internet) are essential for protecting large holdings. These technologies reduce the risk of unauthorized access and hacker attacks.
2. Use a third-party escrow service: A reliable third-party escrow service acts as an intermediary to hold funds or assets until both parties fulfill their obligations. Escrow arrangements can minimize the risk of one party defaulting, especially in large transactions.
3. Clearly stipulate the content of the contract: A clearly drafted contract can specify terms such as delivery schedule, payment method and dispute resolution mechanism to reduce ambiguity. For example, a jurisdiction clause can allow the parties to resolve disputes in accordance with the agreed dispute resolution venue and applicable law when disputes arise.
Through the above measures, virtual currency traders can effectively reduce the three major risks of illegal crimes, data leakage and transaction losses, and protect their own interests. Although these measures are relatively effective, there is no strategy that can completely eliminate these risks in the decentralized and globalized nature of OTC transactions. Retail investors must remain vigilant, take proactive actions, and be prepared to deal with potential disputes to protect their assets and interests.
in conclusion
The Hong Kong virtual currency market provides a wealth of opportunities for retail investors, but it is also accompanied by complex risks and challenges. From illegal crimes, data leaks to trading losses, each risk may pose a threat to investors' lives, property and information. Therefore, before entering this market, retail investors must be fully prepared, not only to understand the relevant laws and regulations, but also to master the basic knowledge of virtual currency transactions.
Compliance operations, enhanced security awareness and rational investment are the keys for retail investors to deal with risks. At the same time, understanding local laws and regulations and seeking support from professional consultants can effectively safeguard their own rights and interests in a complex market environment. Only by maintaining a cautious attitude can retail investors achieve long-term growth in the virtual currency market and surf with peace of mind.