DOTTED across Hong Kong are small shops that convert between cash and crypto with few questions asked, a modern-day echo of the city’s freewheeling past. Soon, many may shut under a looming crackdown.

Officials estimate that 450 shops, automated teller machines and websites in Hong Kong offer such services. They are a key slice of over-the-counter or OTC crypto trades, which accounted for the bulk of the US$64 billion in digital assets that flowed through the city in the year to June, according to Chainalysis.

Some crypto shops are suspected of facilitating banned activity, for instance, Chinese nationals flouting foreign transfer limits or scammers luring investors into frauds.

Against that backdrop, Hong Kong plans a licensing regime under the customs department that will force crypto OTC providers to collect customer records and add staff to monitor for misconduct, portending a jump in costs.

The city, in parallel, is aiming for a deck of tightly regulated crypto exchanges as the main alternative to the OTC route into digital assets. Such exchanges face a Feb 29 deadline to obtain or apply for a permit under a rule book imposed by the Securities and Futures Commission (SFC) in mid-2023.

“Consolidation” likely

The planned OTC framework “will lead to consolidation and a reduction in the use of these platforms as on-ramps into crypto”, said Chengyi Ong, Asia-Pacific policy head at Chainalysis, which tracks digital-asset transactions. Providers will have to better manage crime, cybersecurity and other operational risks, she said.

GET BT IN YOUR INBOX DAILY

Start and end each day with the latest news stories and analyses delivered straight to your inbox.

Sign UpVIEW ALL

Hong Kong’s Financial Services and the Treasury Bureau (FSTB) this month began a consultation till Apr 12 on the OTC rules. The focus is on preventing money laundering, terrorism financing and fraudulent activity. The provisions will not apply to service providers, such as digital-asset exchanges, that are already subject to robust SFC or Hong Kong Monetary Authority oversight.

Bringing the city’s customs department into the mix alongside the other agencies risks giving the impression of regulations being devised on a “piecemeal basis”, said Jason Chan, a Hong Kong-based partner at law firm Howse Williams, which specialises in financial regulatory advice.

A spokesperson for the FSTB said the customs department is the most appropriate authority to oversee crypto OTC service providers, given the agency’s experience. The planned rule book delivers needed controls and maximum investor protection, the spokesperson added.

Rising costs

One of Hong Kong’s OTC companies is One Satoshi, which operates a chain of stores. Co-founder Roger Li said the business mostly serves retail investors, typically for small trades of HK$10,000 (S$1,717) or less.

While the firm already conducts anti-money laundering and know-your-customer checks, new requirements related to compliance staff and record-keeping may lift costs, Li said. OTC firms “will either have to stop the crypto business or apply for the new licence”, he said, adding more guidance is awaited.

Hong Kong pivoted towards fostering a digital asset hub in late 2022, part of an effort to appear cutting-edge amid doubts about the city’s future, given Beijing’s growing control over the former British colony. The SFC rolled out rules for crypto exchanges last June, welcoming licence applications while stressing the need for investor protection, given the sector’s history of volatility and fraud.

There are currently two authorised digital-asset exchanges, HashKey Exchange and OSL Group. Some 18 others have applied for permits. The SFC is also open to allowing exchange-traded funds that invest directly in crypto, while the city’s monetary authority is framing rules for stablecoins – a type of token meant to hold a constant value, typically US$1.

Regulatory challenge

“Bringing OTC transactions into the regulatory structure is a natural extension of the regime,” said Vince Turcotte, an adviser to crypto exchanges. “The primary impact will be to further legitimise the market in Hong Kong.”

Hong Kong is vying with the likes of Singapore and Dubai to woo digital-asset businesses. The jury is out on how well it will do, as well as whether crypto and its underlying blockchain technology are worth pursuing at scale at all. Last year, the blow-up of the unlicensed JPEX crypto platform in Hong Kong led to HK$1.6 billion of losses, highlighting again the risks in the sector.

The city’s drive to police the industry and surface transactions is far from a straightforward task, given the plethora of crypto platforms globally as well as opportunities for peer-to-peer trading that are challenging to track.

“The decentralised nature of crypto makes the industry very hard to regulate,” said Carlton Lai, head of blockchain research at Daiwa Capital Markets. “There are numerous crypto exchanges and apps based offshore that users can easily access without oversight from the government.” BLOOMBERG