Article reprinted from: Mankiw Blockchain
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 Cryptocurrency OTC Trading
1.1 Definition of Retail Investors and Over-the-Counter (OTC) Trading
Retail investors refer to those who primarily trade cryptocurrencies with small amounts of their own funds.
Over-the-Counter (OTC) trading markets are also known as desk trading markets, referring to trades that occur directly outside of central exchanges.
Exchange trading (also known as on-exchange trading) is based on trust in the exchange; whereas over-the-counter trading is based on trust between the parties involved. Due to the inherent advantages of OTC trading, institutional investors or high-net-worth individuals may also choose OTC trading for large transactions.
On February 8, 2024, the Hong Kong government released a public consultation document on (Legislative Proposals for Regulating Virtual Asset OTC Trading), which proposes defining 'virtual asset OTC trading' as:
Providing virtual asset spot trading services in a business capacity, whether through physical stores (including ATMs) or other forms (such as internet platforms), explicitly excludes trading platforms that have obtained VASP licenses.
Considering that 'virtual asset over-the-counter trading' only includes services provided in a business form, personal sales of virtual assets 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 cryptocurrencies through OTC.
1.2 Main Forms of Cryptocurrency OTC Trading in Hong Kong
Cryptocurrency OTC trading in Hong Kong can generally be divided into online and offline forms.
Online: refers to buying and selling cryptocurrencies directly between users without the involvement of intermediaries. Generally, a platform serves as a matching intermediary, but the flow of funds and cryptocurrencies 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 such as OKEx.
Offline: refers to face-to-face communication to complete transactions through personal networks and other channels, such as numerous virtual currency exchange shops and ATM exchange machines that once scattered the streets of Hong Kong, providing convenient physical channels for converting virtual currencies.
According to preliminary estimates from Hong Kong law enforcement agencies, there are approximately 200 physical virtual asset OTC trading shops (including those operated by ATMs) in operation throughout Hong Kong, as well as around 250 active online providers of virtual asset trading services.
Cryptocurrency OTC trading has advantages such as trading flexibility, reduced price slippage, and lower participation thresholds, making it relatively friendly for retail investors who are new to cryptocurrencies.
Main Risks for Retail Investors Participating in Cryptocurrency OTC Trading
2.1 Overview of Cryptocurrency OTC Trading Risks
Although OTC trading offers benefits such as reduced price slippage and increased privacy, it also carries significant trading risks, such as:
1. Illegal Activity Risk: Retail investors in OTC trading, especially in cross-border transactions, may easily incur legal liabilities for violating various regulations regarding civil, administrative, criminal, and tax matters in different jurisdictions.
2. Data Breach Risk: Due to OTC operators failing to protect retail investors' personal data or encountering hacking attacks, personal privacy information may be leaked.
3. Trading Loss Risk: Loss of property due to non-compliance by OTC operators, market volatility, price manipulation, or counterparty default.
Due to stricter cryptocurrency regulations on the mainland, Hong Kong OTC trading provides an important trading channel for mainland investors, which is particularly significant. Therefore, this article will highlight risks for retail investors in conjunction with the legal provisions of both regions.
2.2 Illegal Activity Risk
While retail traders generally have lower frequency and smaller amounts of cryptocurrency liquidation needs, in practice, they still face illegal activity risks. Specifically manifested as:
1. Retail investors may be suspected of money laundering or operating illegal gambling activities, leading to frozen accounts due to receiving illicit funds. Unlike traditional centralized exchanges, where both parties trade based on trust in the platform, OTC trading relies on the trust level between both parties. Some OTC counterparties may exploit information asymmetry to set traps for inexperienced retail investors, enticing them to accept potentially better prices, thus turning them into tools for laundering money. Additionally, some unscrupulous OTC operators may themselves be involved in illegal activities, or certain criminal groups may use OTC operators for money laundering activities. Finally, Hong Kong's anti-money laundering (AML) and counter-terrorism financing (CTF) regulations also require retail investors conducting OTC transactions in Hong Kong to remain vigilant to avoid legal liabilities due to violations.
2. Legal liabilities for buying and selling foreign exchange in violation of foreign exchange management regulations. In Hong Kong OTC transactions, exchanges between various fiat currencies and virtual currencies are quite common. According to the (Regulations on Foreign Exchange Management of the People's Republic of China), unauthorized buying and selling of foreign exchange, disguised buying and selling of foreign exchange, or illegally introducing large amounts of foreign exchange trading will result in warnings, confiscation of illegal gains, and fines from the foreign exchange management authorities; if a crime is constituted, criminal responsibility will be pursued. If retail investors earn profits from exchange rate differences by providing cross-border exchange and payment services using virtual currencies, it constitutes circumventing national foreign exchange regulation through the unique properties of virtual currencies, and the conversion of foreign exchange and RMB through 'foreign exchange - virtual currency - RMB' exchanges will often lead to criminal liability for illegal business operations.
3. Penalties or imprisonment for violating Hong Kong tax laws. Is tax required for virtual currency OTC trading in Hong Kong? According to Section 47 of the Hong Kong Inland Revenue Department's (Interpretation and Practice Note 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 subject to profits tax.
Hong Kong adopts a territorial source tax system, which means only profits generated or sourced from Hong Kong are taxed. Non-Hong Kong residents conducting business activities in Hong Kong must pay taxes on their Hong Kong-sourced profits, while profits sourced outside Hong Kong do not need to be taxed, even if their business operates in Hong Kong. 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 (e.g., sole proprietorships or partnerships), the tax rate on the first HK$2 million of assessable profits is 7.5%.
· The tax rate for amounts exceeding HK$2 million is 15%.
What are the penalties for late tax payment?
Late payment of required taxes may result in the following consequences:
· Fixed penalty HK$10,000,
· The maximum fine can reach three times the amount of unpaid taxes,
· In severe cases, a maximum of three years imprisonment may be imposed (according to the (Penalty Policy) of the Hong Kong Inland Revenue Department).
Of course, if retail investors' cryptocurrency trading in Hong Kong is sporadic and small in amount, such behavior is difficult to consider as 'business' under Hong Kong law and thus does not require review and taxation by the relevant authorities. However, investors engaging in frequent and large transactions must pay extra attention to the relevant tax requirements. Furthermore, future regulatory frameworks may change, warranting close attention.
2.3 Data Breach Risk
1. In OTC trading, the technical complexity of funds settlement and currency transfer increases the difficulty of data security assurance. Large-scale cryptocurrency OTC trading requires handling the transfer of substantial funds and digital assets, which may lead to technical failures and management challenges. 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 trades, such as identity verification, terms negotiation, legal document execution, and transaction record management.
2. Some OTC operators have not implemented effective personal information protection measures, resulting in security vulnerabilities on the platform. Third-party platforms may experience security vulnerabilities. Third-party platforms that facilitate OTC cryptocurrency trading may be susceptible to security breaches and information leaks. This could lead to unauthorized access to sensitive data such as trader identities, transaction details, and other proprietary information. Cybersecurity threats like phishing attacks and malware may exploit these vulnerabilities, jeopardizing the integrity of the platform and the safety of user assets.
3. Even well-known exchanges like Huobi faced information leak risks disclosed by white hats in 2021, involving a wide range of OTC trading information, large account information, customer information, internal technical structures, etc. Although Huobi responded that no actual leaks occurred and only white hats downloaded partial data, it is enough to sound the alarm for every retail investor engaging in OTC trading. Additionally, some criminal groups exploit OTC platforms to steal user information, and some unscrupulous OTC platforms even sell user information externally, which is enough to alert every retail investor.
2.4 Trading Loss Risk
1. In cryptocurrency OTC trading, the risk of trading loss is particularly critical. Compared to centralized exchanges, OTC trading requires a higher level of trust between both trading parties, as either party may default, delay fulfilling obligations, or fail to perform completely. The information asymmetry and communication barriers between the two parties can exacerbate trust risks, leading to transaction breakdowns and even trust collapses. Once the foundation of trust is lost, it can have significant negative impacts on future cooperation between trading parties and the overall market environment.
2. Fraud is one of the main risks in the OTC market, especially in cases involving large amounts of money or cross-border transactions. For example, a counterparty may fabricate their identity and falsely claim or exaggerate their ability to deliver virtual assets, signing or fabricating transaction terms through deceptive means. A common scam is fraudulent refunds, where one party rescinds payment after receiving digital assets.
3. Fraud or bankruptcy of trading facilitators may lead to related losses. In OTC trading, if the party responsible for facilitating the trade commits fraud or goes bankrupt, it may result in related losses for other trading parties. Since trust is a key component of OTC trading, any failure on the part of the facilitator can create a chain reaction that harms the property of all trading participants.
4. In cross-border transactions, especially between the mainland and Hong Kong, trading risks become more pronounced due to differences in legal systems, regulatory frameworks, and enforcement capabilities, which increase the complexity of trades. Jurisdictional issues may make it difficult to seek legal remedies in the event of a breach or fraud by one party. Additionally, factors such as language barriers, differing document standards, and conflicts in legal interpretations may exacerbate misunderstandings or increase the likelihood of other disputes.
How can retail investors protect themselves and achieve compliant trading?
3.1 How to cope with illegal activity risks?
1. Enhance compliance awareness: Cryptocurrency OTC traders should always pay attention to the latest regulatory developments, especially regarding anti-money laundering (AML), counter-terrorism financing (CTF), and tax compliance requirements.
2. Avoid participating in suspicious transactions: Do not purchase cryptocurrencies from unknown sources to avoid becoming part of an illegal money flow; also, keep records of all transaction details in case you need to prove the legitimate source of funds to regulatory authorities.
3. Seek professional support: Look for professional lawyers familiar with cryptocurrency trading and related laws to provide comprehensive support on license applications, compliance agreement drafting, and dispute resolution.
3.2 How to cope with data breach risk?
1. Due Diligence: Conducting thorough due diligence is essential. This includes verifying the identity of the counterparty, assessing its financial stability, and reviewing its trading history. Tools such as Know Your Customer (KYC) procedures and background checks can provide valuable information.
2. Be cautious when submitting personal information: Provide personal identification information (e.g., KYC) to trading platforms only when necessary, and avoid disclosing sensitive information to third parties.
3. Pay attention to cybersecurity: Access trading accounts only through trusted devices (e.g., personal computers or phones), avoid using public Wi-Fi, and set complex passwords for accounts, changing them regularly.
3.3 How to cope with trading loss risk?
To cope with trading loss risk, traders should strengthen their technical protective measures. For example:
1. Secure storage of funds: Multi-signature wallets and cold storage (offline wallets that are not connected to the internet) are crucial for protecting large holdings. These technologies reduce the risk of unauthorized access and hacking.
2. Use third-party escrow services: Use a reliable third-party escrow service to hold funds or assets before both parties fulfill their obligations. Escrow arrangements can minimize the risk of one party defaulting, especially in large transactions.
3. Clearly define the contract terms: A clearly drafted contract can specify terms such as delivery schedules, payment methods, and dispute resolution mechanisms, reducing ambiguity. For example, jurisdiction clauses can allow both parties to resolve disputes according to the agreed dispute resolution location and applicable law.
By implementing these measures, cryptocurrency traders can effectively reduce the three major risks of illegal activities, data breaches, and trading losses, protecting their interests. Although these measures are relatively effective, no strategy can completely eliminate these risks due to the inherent decentralization and globalization characteristics 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 Hong Kong cryptocurrency market offers retail investors abundant opportunities but also presents complex risks and challenges. From illegal activities and data breaches to trading losses, each risk may threaten investors' personal safety, property, and information. Therefore, retail investors must prepare thoroughly before entering this market, understanding relevant laws and regulations while mastering the basics of cryptocurrency trading.
Compliance operations, enhanced security awareness, and rational investment are key for retail investors to cope with risks. Additionally, understanding local laws and regulations and seeking support from professional advisors can effectively protect their rights and interests in a complex market environment. Only by maintaining a cautious attitude can retail investors achieve long-term growth and surf safely in the cryptocurrency market.