Regulation of Over-the-Counter Virtual Asset Trading in Hong Kong: A Comprehensive Analysis

Abstract

Over-the-counter (OTC) trading has historically represented a significant, yet largely opaque and unregulated, segment of the burgeoning virtual asset market. This lack of oversight rendered it susceptible to a range of illicit activities, including sophisticated money laundering schemes, terrorist financing operations, and various forms of market manipulation, thereby posing substantial risks to financial stability and investor protection. Recognizing these inherent vulnerabilities and Hong Kong’s strategic ambition to become a leading global virtual asset hub, the jurisdiction has proactively introduced a comprehensive suite of regulatory measures. These initiatives are meticulously designed to inject greater transparency, bolster investor confidence, and fortify the integrity of the OTC virtual asset trading sector. This detailed report undertakes an exhaustive analysis of Hong Kong’s evolving regulatory framework specifically targeting OTC virtual asset trading, tracing its historical development, dissecting its core legislative and operational components, and evaluating its far-reaching implications for both the local and international virtual asset ecosystem. The aim is to demonstrate Hong Kong’s commitment to fostering a responsible and sustainable environment for virtual asset innovation within a robust regulatory paradigm.

Many thanks to our sponsor Panxora who helped us prepare this research report.

1. Introduction

The virtual asset market has undergone an unprecedented period of expansion and technological innovation over the past decade, giving rise to a diverse array of trading mechanisms and financial instruments. Among these, over-the-counter (OTC) trading has emerged as a particularly prominent method for transacting virtual assets, distinguishing itself from centralized exchange-based trading. OTC transactions involve direct, bilateral dealings between two parties, effectively bypassing the order books and public price discovery mechanisms characteristic of traditional or centralized virtual asset exchanges. This modality has gained considerable traction within the virtual asset space, primarily due to its perceived advantages in terms of flexibility, privacy, and the capacity to execute large-block trades without significantly impacting public market prices or liquidity.

However, the very attributes that make OTC trading attractive — namely its decentralized nature and historical lack of centralized oversight — have simultaneously contributed to significant regulatory challenges. The absence of a robust regulatory framework in this specific segment has ignited widespread concerns across global financial authorities regarding potential ramifications for financial stability, the adequacy of investor protection mechanisms, and its potential exploitation for illicit financial activities. These illicit uses, particularly money laundering (ML) and terrorist financing (TF), are amplified by the pseudonymous nature of many virtual assets and the cross-border fluidity of their transactions. The inherent opacity of OTC deals also makes them fertile ground for market manipulation, insider trading, and various forms of fraud, leaving individual and institutional investors vulnerable without adequate recourse.

Hong Kong, a globally recognized financial services hub with a long-standing commitment to regulatory excellence and market integrity, has keenly observed these emerging challenges. Aspiring to cement its position as a leading international centre for virtual asset innovation, the Hong Kong government and its regulatory bodies have proactively acknowledged the imperative to address the regulatory void in OTC virtual asset trading. By taking decisive steps to bring this segment under a clear regulatory umbrella, Hong Kong aims not only to mitigate the identified risks but also to cultivate an environment of trust and certainty, essential for attracting legitimate businesses and institutional capital to its burgeoning virtual asset economy. This proactive stance underscores Hong Kong’s balanced approach: fostering innovation while rigorously upholding international standards for financial crime prevention and investor safeguarding.

Many thanks to our sponsor Panxora who helped us prepare this research report.

2. Evolution of Hong Kong’s Regulatory Framework for OTC Virtual Asset Trading

Hong Kong’s approach to regulating the virtual asset sector has been characterized by a gradual, risk-based, and iterative process, evolving as the market matured and new risks became apparent. The regulation of OTC virtual asset trading represents a significant advancement in this continuous effort.

2.1 Initial Regulatory Landscape: A Focus on Centralized Platforms

Historically, OTC virtual asset trading in Hong Kong operated within a largely unregulated milieu, existing in a ‘grey area’ where specific legislation for these direct bilateral transactions was absent. The initial focus of Hong Kong’s principal financial regulators, particularly the Securities and Futures Commission (SFC) and the Hong Kong Monetary Authority (HKMA), was predominantly directed towards centralized virtual asset trading platforms (VATPs). This strategic priority stemmed from the recognition that VATPs, by facilitating multi-lateral trading and often holding client assets, presented more immediate and discernible risks related to market integrity, investor protection, and systemic stability.

In November 2019, the SFC launched its opt-in regulatory framework for VATPs, which later became mandatory in June 2023. This framework primarily targeted platforms that offered trading in virtual assets deemed to be ‘securities’ or ‘futures contracts’ under the Securities and Futures Ordinance (SFO). Over time, the scope expanded to cover all VATPs operating in Hong Kong, regardless of whether the virtual assets traded were classified as securities. The SFC’s comprehensive approach mandated strict licensing requirements (Type 1 and Type 7 regulated activities), robust investor protection measures, rigorous anti-money laundering and counter-terrorist financing (AML/CTF) controls, and stringent cybersecurity standards. The rationale was that these centralized entities, functioning akin to traditional financial intermediaries, necessitated a similar level of regulatory oversight to protect public investors and maintain financial order. The SFC’s 2021 statement, titled ‘Statement on regulatory framework for virtual asset portfolios managers, fund distributors and trading platform operators,’ further emphasized the growing concerns surrounding unregulated virtual asset activities and the severe lack of investor protection prevalent in such environments (Securities and Futures Commission of Hong Kong, 2021).

However, the direct, peer-to-peer, or broker-facilitated nature of OTC transactions meant they fell largely outside the purview of the SFC’s initial VATP-focused regime. While existing AML/CTF legislation applied broadly to financial institutions, it did not specifically cater to dedicated virtual asset OTC service providers as a distinct regulated entity. As the virtual asset market expanded, so too did the volume and sophistication of OTC transactions. This led to a growing awareness among regulators that the unregulated OTC sector posed an increasing threat, serving as a potential conduit for large-scale illicit fund flows that could bypass the more stringent controls imposed on licensed VATPs. The international community, particularly through the Financial Action Task Force (FATF), also began to emphasize the need to regulate all Virtual Asset Service Providers (VASPs), a category that explicitly includes OTC desks and brokers, further pressing Hong Kong to close this regulatory gap.

2.2 Public Consultation and Legislative Proposals: Addressing the Regulatory Gap

In direct response to these accumulating concerns and the evolving international regulatory landscape, the Financial Services and the Treasury Bureau (FSTB), as Hong Kong’s principal policy bureau overseeing financial services and treasury matters, initiated a critical legislative process. On February 8, 2024, the FSTB formally launched a public consultation on legislative proposals aimed at establishing a dedicated licensing regime for providers of OTC virtual asset trading services (Financial Services and the Treasury Bureau, 2024). This consultation marked a pivotal moment, signaling Hong Kong’s determined effort to extend its regulatory reach to this previously under-supervised segment of the virtual asset market.

The primary objective of this public consultation was multifaceted: to address the identified regulatory gap in OTC virtual asset trading, to mitigate the significant risks associated with money laundering and terrorist financing, and to enhance overall market integrity and investor confidence. The FSTB’s proposals were comprehensive, aiming to cover a broad spectrum of OTC activities. Key proposals outlined in the consultation paper included:

• Mandatory Licensing Requirement: A foundational proposal was the requirement for any person or entity conducting a business that provides spot trading services of virtual assets in Hong Kong to obtain a license. This move signified a shift from a largely unregulated environment to a mandatory licensing framework, ensuring that all operators meet a minimum standard of conduct and financial soundness.
• Broad Scope of Covered Services: The proposed regime was designed to be technology-neutral and comprehensive, encompassing all forms of OTC services. This explicitly included services provided through physical outlets, such as dedicated storefronts or kiosks, as well as those offered via online platforms, mobile applications, or other digital interfaces. This broad definition aimed to prevent regulatory arbitrage by ensuring consistent oversight regardless of the delivery channel.
• Designation of the Commissioner of Customs and Excise (CCE) as Regulator: A crucial aspect of the proposal was the designation of the Commissioner of Customs and Excise (CCE) as the primary licensing and supervisory authority for these OTC virtual asset service providers. This choice was strategic, leveraging the CCE’s extensive experience and existing mandate in supervising Money Service Operators (MSOs), such as money changers and remittance agents, for AML/CTF compliance under the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO). This alignment allowed for a more coherent and integrated approach to financial crime prevention across different money service sectors.
• Enhanced CCE Powers: To effectively carry out its supervisory duties, the CCE would be granted comprehensive powers. These powers would include the authority to issue licenses, impose licensing conditions, conduct regular inspections, investigate potential breaches of regulatory requirements, and apply appropriate enforcement actions, including sanctions, fines, and license revocation. These powers are critical for ensuring compliance and deterring illicit activities.

The public consultation period allowed industry stakeholders, legal professionals, academics, and the general public to provide feedback on the proposed legislative framework. This consultative approach is a hallmark of Hong Kong’s policy-making process, ensuring that regulations are robust, pragmatic, and consider the practical implications for market participants.

2.3 Implementation of the Licensing Regime: A New Era of Oversight

Following the conclusion of the public consultation and careful consideration of the feedback received, Hong Kong moved forward with the implementation of the licensing regime for OTC virtual asset trading services. This implementation represents a landmark development, marking the formal integration of this sector into Hong Kong’s regulated financial landscape. The legislative amendments are expected to provide the legal basis for the CCE to commence its duties as the dedicated regulator for OTC virtual asset service providers (KPMG, 2024).

Under this newly enacted regime, all entities wishing to provide spot trading services of virtual assets in Hong Kong are legally mandated to obtain a license from the CCE. This shift transforms OTC virtual asset trading from a largely unregulated activity into a supervised financial service. The licensing process is designed to be rigorous, involving detailed scrutiny of applicants’ operational models, financial health, management expertise, and most importantly, their commitment to robust compliance frameworks. This includes meeting stringent eligibility criteria, adhering to prescribed operational standards, and demonstrating comprehensive compliance with anti-money laundering and counter-terrorist financing (AML/CTF) regulations.

Key aspects of the implementation include:

• Defined Scope of Virtual Assets: The CCE’s remit primarily covers virtual assets that are not defined as securities or futures contracts under the SFO. This delineation avoids overlap with the SFC’s jurisdiction over VATPs trading security tokens, establishing a clear dual-track regulatory approach for virtual assets in Hong Kong. However, it requires careful coordination between the CCE and SFC, especially for businesses that might offer both types of services or deal with a broad range of virtual assets whose classification might evolve.
• Transition Arrangements: For existing OTC virtual asset service providers operating in Hong Kong prior to the full enactment of the regime, specific transition arrangements or grace periods are typically provided. These arrangements allow current operators sufficient time to prepare their applications, adjust their internal systems, and meet the new regulatory requirements without immediate disruption to their services. However, operating without a valid license after the transition period will be a criminal offense.
• Inter-agency Coordination: The success of this dual-track regulatory model — with the SFC supervising VATPs and the CCE overseeing OTC VA services — hinges on seamless coordination between the two agencies. Mechanisms for information sharing, joint investigations, and consistent interpretation of regulatory principles are crucial to ensure a cohesive and effective virtual asset regulatory landscape in Hong Kong. This collaboration aims to prevent regulatory arbitrage and ensure comprehensive oversight across the entire virtual asset value chain.

The full implementation of this licensing regime sends a clear message to both local and international markets: Hong Kong is serious about establishing a well-regulated and responsible ecosystem for virtual assets, fostering legitimate innovation while proactively combating financial crime.

Many thanks to our sponsor Panxora who helped us prepare this research report.

3. Key Components of the Regulatory Framework

Hong Kong’s regulatory framework for OTC virtual asset trading is built upon three foundational pillars: stringent licensing requirements, comprehensive operational standards, and robust anti-money laundering and counter-terrorist financing (AML/CTF) compliance. These components collectively ensure that licensed entities operate with integrity, transparency, and a high degree of accountability.

3.1 Licensing Requirements: The Gateway to Regulated Operations

The licensing regime administered by the Commissioner of Customs and Excise (CCE) imposes a series of stringent conditions that applicants must satisfy before being granted a license to operate an OTC virtual asset trading service. These requirements are designed to ensure that only ‘fit and proper’ entities with robust governance structures and sufficient resources are allowed to operate, thereby safeguarding market integrity and investor interests.

• Entity Incorporation and Registration: A fundamental prerequisite is that the applicant must be an entity incorporated in Hong Kong or registered under the Companies Ordinance (Cap. 622) of Hong Kong. This requirement ensures that the legal entity is domiciled within Hong Kong’s jurisdiction, making it amenable to local laws, regulatory oversight, and enforcement actions. This also facilitates effective communication and supervision by the CCE.

• Fit and Proper Criteria for Directors and Management: All directors, responsible officers, and ultimate owners of the applicant entity will undergo rigorous ‘fit and proper’ assessments. This involves comprehensive background checks to ascertain their reputation, character, financial integrity, and competence. Any history of criminal offenses, financial misconduct, or association with illicit activities would likely disqualify individuals, ensuring that key decision-makers uphold the highest ethical standards. This criterion is vital for preventing bad actors from entering the regulated space.

• Appointed Key Personnel: Licensees are mandated to appoint specific key personnel responsible for critical compliance functions. These include:

  • Competent Compliance Officer (CO): The CO is responsible for ensuring the licensee’s adherence to all relevant laws, regulations, and internal policies. This role requires an individual with demonstrated expertise in regulatory compliance, particularly within the financial services or virtual asset sector. The CO is typically responsible for developing, implementing, and monitoring the licensee’s internal compliance policies and procedures, overseeing staff training, and acting as the primary liaison with the CCE on compliance matters. Their reporting lines must be clear, often directly to senior management or the board, to ensure independence and authority.
  • Money Laundering Reporting Officer (MLRO): The MLRO is a critical figure in the AML/CTF framework, responsible for receiving internal suspicious activity reports, investigating them, and, where appropriate, filing Suspicious Transaction Reports (STRs) with Hong Kong’s Joint Financial Intelligence Unit (JFIU) via the CCE. The MLRO must possess deep knowledge of AML/CTF laws, typologies of financial crime, and the specific risks associated with virtual assets. This individual typically has direct access to senior management and enjoys sufficient authority to ensure that AML/CTF obligations are met without undue influence.

• Robust Internal Controls and Risk Management Systems: Applicants must demonstrate that they have established and will maintain comprehensive internal control and risk management systems. These systems are designed to identify, assess, monitor, and mitigate a wide range of operational, financial, legal, and compliance risks inherent in virtual asset trading. Specific areas include:

  • Cybersecurity Frameworks: Given the digital nature of virtual assets, robust cybersecurity measures are paramount. This includes secure IT infrastructure, data encryption, multi-factor authentication, regular penetration testing, and incident response plans to protect against hacking, data breaches, and service disruptions.
  • Operational Resilience: Plans for business continuity and disaster recovery to ensure services can withstand unexpected events.
  • Client Asset Segregation (if applicable): While OTC often involves direct transfer, if the licensee temporarily holds client funds or virtual assets, clear policies for segregation of client assets from firm assets are required to prevent commingling and protect client interests in case of firm insolvency.
  • Conflict of Interest Policies: Mechanisms to identify and manage potential conflicts of interest, particularly in a brokerage or market-making capacity.
  • Record-keeping Systems: Secure and auditable systems for retaining all transaction data, client identification records, and communications.

• Financial Resources: While not explicitly detailed in the original extract, licensing regimes typically require licensees to maintain a minimum level of paid-up capital and liquid assets. These requirements ensure the financial stability of the operator and provide a buffer against operational losses or unforeseen liabilities, thereby protecting clients and the broader market.

3.2 Operational Standards: Ensuring Fair and Orderly Conduct

Beyond initial licensing, the framework imposes ongoing operational standards that licensees must continuously adhere to. These standards are critical for promoting transparency, efficiency, and fairness in the conduct of OTC virtual asset trading services.

• Maintaining Proper Records of All Transactions: Licensees are obligated to maintain meticulous and accurate records of all virtual asset transactions executed. This includes comprehensive details such as the identity of the transacting parties, the type and quantity of virtual assets involved, the fiat currency equivalent (if applicable), the date and time of the transaction, the exchange rate or price, and any associated fees. These records must be kept in a secure, immutable, and easily retrievable format for a prescribed period (typically 5-7 years, consistent with AML/CTF requirements). This is crucial for audit trails, regulatory scrutiny, and forensic investigations.

• Conducting Regular Audits and Compliance Reviews: To ensure continuous adherence to regulatory requirements and internal policies, licensees must implement a program of regular internal and external audits. Internal audits assess the effectiveness of controls and compliance functions, while external audits provide an independent verification of financial statements and operational integrity. Compliance reviews should also be conducted regularly, particularly when introducing new products, services, or significant operational changes, to ensure they remain within regulatory boundaries. Findings from these audits and reviews must be documented, and any deficiencies identified must be promptly addressed and reported to the CCE as required.

• Ensuring Transparency in Pricing and Execution of Trades: One of the historical criticisms of OTC markets is their opacity regarding pricing. The regulatory framework addresses this by requiring licensees to ensure transparency in their pricing mechanisms. This involves clearly disclosing to clients how prices are determined (e.g., based on aggregated exchange rates plus a spread), any applicable fees or commissions, and the methodology for order execution. Pre-trade disclosures and post-trade confirmations should be clear, comprehensive, and understandable to clients. The aim is to prevent predatory pricing, hidden fees, and ensure clients receive fair execution in line with agreed terms, even in a bilateral trading environment.

• Client Communication and Disclosures: Licensees are required to provide clear and unambiguous terms and conditions of service, including disclosures of risks associated with virtual asset trading. This empowers clients to make informed decisions and understand the nature of the services they are engaging in.

• Cybersecurity and Data Protection: Continuous adherence to robust cybersecurity practices is an operational imperative. This includes regular system updates, vulnerability assessments, staff training on cyber hygiene, and strict protocols for handling client data in accordance with Hong Kong’s privacy laws.

3.3 Anti-Money Laundering and Counter-Terrorist Financing (AML/CTF) Compliance: A Global Imperative

AML/CTF compliance forms the bedrock of Hong Kong’s financial regulatory system and is a central pillar of the OTC virtual asset licensing regime. As virtual assets can be easily transferred across borders with relative anonymity, they pose inherent risks for facilitating illicit financial flows. The CCE, with its expertise in AML/CTF supervision, plays a crucial role in enforcing these obligations, aligning Hong Kong with international standards set by the Financial Action Task Force (FATF), particularly Recommendation 15 concerning Virtual Assets and Virtual Asset Service Providers (VASPs).

Licensees are obligated to implement comprehensive AML/CTF programs that include:

• Customer Due Diligence (CDD) and Enhanced Due Diligence (EDD): This is the cornerstone of AML/CTF. Licensees must:

  • Conduct CDD: This involves identifying and verifying the identity of all customers, whether individuals or corporate entities. For individuals, this means collecting valid identification documents (e.g., passports, HKIDs) and verifying their authenticity. For corporate clients, it involves understanding the corporate structure, identifying beneficial owners (individuals who ultimately own or control the entity), and verifying their identities. CDD also requires understanding the nature and purpose of the business relationship.
  • Implement a Risk-Based Approach: Not all customers or transactions pose the same level of risk. Licensees must develop a risk-based approach to CDD, applying simpler measures for lower-risk scenarios and more intensive measures for higher-risk ones. This approach optimizes resource allocation while maintaining effective risk mitigation.
  • Perform EDD: Enhanced Due Diligence is required for customers or transactions identified as high-risk. Triggers for EDD include politically exposed persons (PEPs), customers from high-risk jurisdictions (as identified by FATF), unusually large or complex transactions, or transactions with no apparent economic or lawful purpose. EDD measures might include obtaining additional information on the customer’s source of funds and source of wealth, seeking senior management approval for the relationship, and conducting more intensive ongoing monitoring.

• Reporting Suspicious Transactions: Licensees have a legal obligation to report suspicious transactions to the relevant authorities. This involves:

  • Internal Reporting: Any employee who suspects a transaction or activity is linked to money laundering or terrorist financing must report it internally to the MLRO.
  • External Reporting (STRs): The MLRO, after conducting an internal assessment, must file a Suspicious Transaction Report (STR) with the Joint Financial Intelligence Unit (JFIU) if there are reasonable grounds to suspect that funds are proceeds of crime or linked to terrorist financing. The ‘tipping-off’ prohibition, which forbids informing the customer that an STR has been filed, is strictly enforced.
  • Red Flag Indicators: Licensees must train their staff to recognize ‘red flag’ indicators specific to virtual asset transactions, such as unusual transaction patterns, attempts to avoid CDD, large one-off transactions, or rapid transfers of virtual assets without clear economic rationale.

• Implementation of Measures to Detect and Prevent Money Laundering and Terrorist Financing Activities: This encompasses a broad range of proactive measures, including:

  • Ongoing Transaction Monitoring: Systems and processes to continuously monitor customer transactions and activities for any unusual or suspicious patterns that deviate from their normal profile. This can involve both automated systems and manual reviews.
  • Sanctions Screening: Regularly screening customers and transactions against international sanctions lists (e.g., United Nations Security Council resolutions, OFAC sanctions) to ensure compliance with financial sanctions regimes.
  • Adherence to Travel Rule: The FATF’s ‘Travel Rule’ requires VASPs to obtain and transmit certain originator and beneficiary information in virtual asset transfers above a de minimis threshold. Hong Kong’s framework requires compliance with this rule to enhance transparency in virtual asset flows.
  • Training and Awareness: Regular and mandatory training for all staff, particularly front-line personnel and compliance officers, on AML/CTF policies, procedures, risk indicators, and their reporting obligations.
  • Blockchain Analytics: Leveraging specialized blockchain analytics tools to trace virtual asset flows, identify suspicious addresses, and conduct enhanced due diligence on counterparties in transactions.

By embedding these comprehensive AML/CTF obligations, Hong Kong aims to prevent its OTC virtual asset sector from being exploited by criminals, thereby safeguarding its reputation as a clean and compliant financial centre.

Many thanks to our sponsor Panxora who helped us prepare this research report.

4. Implications for the Virtual Asset Market

Hong Kong’s proactive regulatory stance on OTC virtual asset trading carries profound implications that extend beyond mere compliance, shaping the future trajectory of the virtual asset market within the jurisdiction and influencing its standing on the global stage.

4.1 Enhanced Investor Protection: Building Trust Through Oversight

The introduction of a mandatory licensing regime for OTC virtual asset service providers fundamentally transforms the landscape of investor protection. Previously, individual investors engaging in OTC transactions often operated in a legal void, lacking recourse in cases of fraud, misrepresentation, or operational failure. The new framework directly addresses these vulnerabilities by:

• Establishing Minimum Standards of Conduct: Licensed entities are compelled to adhere to a baseline of ethical conduct, financial prudence, and operational integrity. This includes requirements for fair pricing, transparent fee structures, and reliable execution of trades, significantly reducing the likelihood of predatory practices.
• Reducing Fraud and Market Manipulation: The ‘fit and proper’ criteria for licensees’ management and the stringent AML/CTF obligations act as formidable gatekeepers, deterring illicit actors. By monitoring transactions and requiring robust internal controls, the framework makes it significantly harder for OTC desks to facilitate scams, insider trading, or pump-and-dump schemes that previously thrived in unregulated environments.
• Providing Recourse Mechanisms: In a regulated environment, investors who suffer losses due to a licensee’s misconduct or negligence have clear avenues for redress, whether through regulatory complaints, civil actions, or potentially compensation schemes (though specific details of the latter would depend on further policy development). This contrasts sharply with the virtually non-existent legal remedies available against unregulated entities.
• Promoting Informed Decision-Making: The requirement for clear disclosures of risks, terms, and conditions ensures that investors are better informed about the nature of virtual assets and the services they are utilizing, empowering them to make more prudent investment choices.
• Segregation of Client Assets: Where licensees temporarily hold client funds or virtual assets, explicit requirements for segregation from proprietary assets protect clients in the event of the firm’s insolvency, a crucial safeguard that was absent in the unregulated past.

Ultimately, enhanced investor protection fosters a safer trading environment, which is vital for building trust among retail and institutional investors, encouraging broader participation in the virtual asset market.

4.2 Increased Market Integrity: Fostering a Robust and Trusted Ecosystem

Regulation of the OTC sector is a critical step towards elevating the overall integrity of Hong Kong’s virtual asset market. By bringing this previously opaque segment under stringent oversight, the framework aims to:

• Combat Illicit Financial Flows: The core AML/CTF requirements, including robust CDD, transaction monitoring, and suspicious transaction reporting, significantly reduce the attractiveness of Hong Kong’s OTC sector for money laundering, terrorist financing, and other financial crimes. This ‘cleaning up’ of the market prevents it from becoming a haven for illicit funds.
• Improve Price Discovery and Reduce Arbitrage: While OTC inherently involves bilateral pricing, the transparency requirements and increased oversight on large block trades can contribute to more efficient price discovery over time. By reducing the scope for opaque, unregulated arbitrage opportunities, the market becomes fairer and more competitive.
• Attract Institutional Capital: Institutional investors, such as hedge funds, asset managers, and corporate treasuries, are often constrained by mandates that prevent them from engaging with unregulated entities. A regulated OTC market in Hong Kong removes a significant barrier, making the jurisdiction a more viable and attractive destination for substantial institutional capital seeking exposure to virtual assets.
• Promote Fair Competition: By standardizing compliance costs and operational requirements across all licensed operators, the framework fosters a level playing field, discouraging unfair advantages previously enjoyed by unregulated entities that bypassed compliance expenses.
• Reduce Systemic Risk: While individual OTC transactions may not pose systemic risk, the cumulative effect of a large, unregulated OTC market could. Bringing it under oversight allows for better monitoring of market activity, aggregate exposure, and potential concentration risks, contributing to overall financial stability.

By enhancing market integrity, Hong Kong aims to cultivate a resilient, trustworthy, and efficient virtual asset ecosystem capable of supporting sustainable growth and innovation.

4.3 Alignment with International Standards: A Responsible Global Player

Hong Kong’s decision to regulate OTC virtual asset trading is not an isolated initiative; rather, it represents a concerted effort to align its domestic regulatory framework with evolving international standards and best practices, particularly those promulgated by the Financial Action Task Force (FATF).

• FATF Compliance: The FATF, the global money laundering and terrorist financing watchdog, has consistently advocated for the regulation of all Virtual Asset Service Providers (VASPs), which explicitly includes OTC virtual asset brokers and dealers. By implementing a licensing regime for OTC services with strong AML/CTF provisions, Hong Kong demonstrates its unwavering commitment to implementing FATF recommendations. This is crucial for maintaining Hong Kong’s standing in the international financial community and avoiding potential ‘grey-listing’ or other adverse classifications.
• Enhanced Global Reputation and Credibility: This proactive regulatory move strengthens Hong Kong’s reputation as a responsible and compliant international financial centre. It signals to global investors, businesses, and peer regulators that Hong Kong is serious about mitigating risks associated with virtual assets while fostering innovation. This enhanced credibility can attract foreign direct investment and high-quality virtual asset businesses seeking a well-regulated environment.
• Facilitation of Cross-border Cooperation: Alignment with international standards facilitates greater cooperation with other jurisdictions in combating financial crime. With similar regulatory frameworks in place, information sharing, mutual legal assistance, and coordinated enforcement actions become more streamlined and effective, creating a more robust global defense against illicit virtual asset flows.
• Competitive Positioning: In the rapidly evolving race among global financial hubs to become virtual asset leaders, regulatory clarity and robustness are increasingly key differentiators. By comprehensively regulating OTC services, Hong Kong distinguishes itself from jurisdictions with fragmented or absent virtual asset regulations, positioning itself competitively against aspiring crypto hubs like Singapore, Dubai, and potentially London.

This alignment reinforces Hong Kong’s commitment to global financial stability and its role as a responsible participant in the international effort to manage the risks and harness the potential of virtual assets.

4.4 Broader Economic Impact: Catalysing Growth and Development

Beyond direct market integrity and investor protection, the regulation of OTC virtual asset trading can have significant positive spillover effects on Hong Kong’s broader economy:

• Job Creation: The establishment of a regulated sector necessitates the hiring of professionals in compliance, legal, risk management, cybersecurity, and technology, contributing to job growth in high-value sectors.
• Attracting Legitimate Businesses: A clear and robust regulatory framework reduces uncertainty, encouraging reputable virtual asset businesses to establish or expand their operations in Hong Kong, bringing capital, talent, and innovation.
• Development of Related Industries: Growth in the regulated virtual asset sector can stimulate demand for ancillary services, such as blockchain analytics, secure custody solutions, professional services (accounting, legal), and specialized insurance.
• Government Revenue: While not the primary driver, a growing and regulated industry provides a clearer basis for future taxation, contributing to government revenue.

By creating a more secure and predictable environment, Hong Kong is laying the groundwork for the sustained and responsible growth of its virtual asset economy.

Many thanks to our sponsor Panxora who helped us prepare this research report.

5. Challenges and Considerations

While Hong Kong’s new regulatory framework for OTC virtual asset trading represents a significant advancement, its implementation and long-term success are contingent upon addressing several inherent challenges and ongoing considerations. These challenges underscore the dynamic nature of the virtual asset space and the complexities of regulatory oversight.

5.1 Balancing Regulation and Innovation: Navigating the Trade-off

One of the most persistent challenges in regulating nascent and rapidly evolving industries like virtual assets is striking the right balance between necessary oversight and fostering innovation. Overly stringent or prescriptive regulations, particularly at an early stage of technological development, can inadvertently stifle creativity, increase compliance costs to prohibitive levels, and push promising startups offshore, thus hindering the growth of the domestic ecosystem.

• Cost of Compliance for Startups: The comprehensive nature of the licensing requirements, operational standards, and AML/CTF obligations can impose significant financial and operational burdens on smaller startups and emerging businesses. Investing in sophisticated compliance systems, hiring skilled personnel (COs, MLROs), and undergoing regular audits requires substantial resources, which might be challenging for thinly capitalized new entrants. This could lead to market consolidation, potentially limiting competition and diversity in service offerings.
• Regulatory Sandboxes and Pilot Programs: To mitigate the risk of stifling innovation, Hong Kong could further leverage and expand its existing regulatory sandbox approaches. These environments allow innovative virtual asset projects to test their products and services in a controlled regulatory setting, with close guidance from regulators, before full-scale public deployment. This provides a learning ground for both innovators and regulators.
• Agile and Technology-Neutral Regulation: The rapid pace of technological advancements in the virtual asset space (e.g., DeFi, NFTs, stablecoins) means that regulations must be adaptable and principles-based rather than overly prescriptive. A technology-neutral approach focuses on the inherent risks of an activity rather than the specific technology used, ensuring the framework remains relevant as new innovations emerge without requiring constant legislative amendments. Regulators must possess the expertise to understand new technologies and their implications swiftly.
• Talent Gap: There is a global shortage of professionals with expertise in both virtual assets and regulatory compliance. Ensuring a sufficient pool of qualified compliance officers, cybersecurity experts, and legal professionals capable of navigating this complex intersection is crucial for successful implementation of the framework.

5.2 Enforcement and Compliance: Ensuring Effectiveness and Reach

The robustness of any regulatory framework ultimately depends on its effective enforcement. Hong Kong faces several challenges in ensuring comprehensive compliance and enforcement in the OTC virtual asset sector.

• Resource Allocation and Expertise for CCE: The Commissioner of Customs and Excise, while experienced in AML/CTF for MSOs, will need to significantly scale up its resources, technological capabilities, and specialized expertise to effectively supervise the complex and often technical virtual asset sector. This includes training staff on blockchain forensics, virtual asset typologies, and the intricacies of decentralized finance, as well as investing in necessary monitoring and analytical tools.
• Identifying and Regulating Unlicensed Operators: A significant challenge remains in identifying and taking enforcement action against unlicensed virtual asset OTC service providers, particularly those operating purely online or targeting Hong Kong residents from offshore. The borderless nature of virtual assets makes jurisdictional reach a complex issue. The CCE will need robust investigative powers and international cooperation mechanisms to tackle this ‘dark market’ effectively. Public awareness campaigns about the risks of using unlicensed services are also crucial.
• Cross-border Jurisdictional Challenges: Virtual asset transactions inherently transcend national borders. Regulating services where either the provider or the client (or both) are located in different jurisdictions requires strong international collaboration, information-sharing agreements, and consistent application of FATF standards globally to prevent regulatory arbitrage.
• Inter-agency Coordination: While the CCE is the primary regulator for OTC VA services and the SFC for VATPs, the lines can sometimes blur, particularly with hybrid business models. Seamless and continuous coordination between the CCE, SFC, HKMA, and the JFIU is paramount to ensure a coherent regulatory approach, prevent overlaps, avoid gaps, and facilitate timely enforcement actions. Clear protocols for intelligence sharing and joint investigations are essential.
• Adequacy of Penalties: The effectiveness of enforcement is also influenced by the severity of penalties for non-compliance. Penalties must be sufficiently deterrent to discourage unlicensed operations and breaches of regulatory obligations. Periodic review of penalty structures will be necessary.

5.3 Market Adaptation: Adjusting to a New Paradigm

The introduction of a new, comprehensive licensing regime requires significant adaptation from market participants, which itself presents challenges.

• Operational Overhaul: Existing OTC virtual asset service providers, particularly those that previously operated with minimal oversight, must undertake a substantial overhaul of their operations. This includes developing and implementing new internal controls, upgrading IT systems for compliance and security, establishing robust record-keeping protocols, and revising customer onboarding processes. This requires significant investment in infrastructure, technology, and personnel.
• Business Model Transformation: Some historical OTC business models, particularly those reliant on absolute anonymity or minimal due diligence, will no longer be viable under the new regime. Operators may need to fundamentally transform their business strategies, potentially focusing on high-value clients who prioritize compliance and security, or specializing in niches that align well with regulatory requirements.
• Consolidation and Exit: The increased compliance burden may lead to consolidation within the industry, as smaller operators find it economically unfeasible to obtain and maintain a license. Some existing players may choose to exit the Hong Kong market entirely rather than adapt, potentially reducing immediate market diversity.
• Industry Education and Training: There is a significant need for industry-wide education and training to ensure that all personnel within licensed entities understand their new obligations, from front-line staff conducting CDD to senior management responsible for overall compliance. This includes understanding the nuances of virtual asset risks and regulatory expectations.
• Client Familiarity with Regulated Services: Clients accustomed to the ease and anonymity of unregulated OTC services may need to be educated about the benefits of using licensed providers, particularly regarding enhanced security and recourse mechanisms, to encourage adoption of the regulated sector.

5.4 Global Regulatory Arbitrage: The Persistent Threat

Despite Hong Kong’s robust framework, the global nature of virtual assets means that regulatory arbitrage remains a persistent concern. Businesses could choose to serve Hong Kong clients from offshore, less regulated jurisdictions, or users might seek out ‘dark market’ services to circumvent regulations. This necessitates ongoing international cooperation and vigilance to prevent a race to the bottom in regulatory standards.

Addressing these challenges will require continuous effort, adaptability, and close collaboration among regulators, industry participants, and international partners to ensure Hong Kong’s virtual asset market develops responsibly and sustainably.

Many thanks to our sponsor Panxora who helped us prepare this research report.

6. Conclusion

Hong Kong’s decisive introduction of a mandatory licensing regime for Over-the-Counter (OTC) virtual asset trading services marks a pivotal and commendable step towards fostering a more transparent, secure, and reputable virtual asset market. This comprehensive framework, meticulously developed to address the inherent opacity and susceptibility to illicit activities previously associated with the OTC sector, signifies Hong Kong’s unwavering commitment to regulatory excellence and financial integrity. By extending regulatory oversight to this critical segment, the jurisdiction aims to bolster investor protection, fortify market integrity against financial crime, and strategically align itself with stringent international standards, notably those advocated by the Financial Services and the Treasury Bureau and the Financial Action Task Force.

The licensing regime, underpinned by rigorous eligibility criteria, robust operational standards, and extensive Anti-Money Laundering and Counter-Terrorist Financing (AML/CTF) compliance obligations, establishes a clear and enforceable mandate for all OTC virtual asset service providers operating within Hong Kong. This proactive approach not only mitigates significant risks of fraud, market manipulation, and illicit financial flows but also lays a credible foundation for attracting legitimate institutional capital and fostering sustainable innovation within the virtual asset ecosystem. The designation of the Commissioner of Customs and Excise (CCE) as the primary supervisory authority, leveraging its proven expertise in AML/CTF, further underscores a strategic and pragmatic approach to enforcement.

However, the path forward is not without its complexities. The regulatory landscape for virtual assets is characterized by rapid technological advancements and evolving business models, necessitating a delicate balance between robust oversight and the imperative to nurture innovation. Challenges persist in ensuring effective enforcement against unlicensed operators, navigating cross-border jurisdictional complexities, and managing the significant adaptation required from market participants. Successfully overcoming these hurdles will demand sustained resource allocation, continuous inter-agency coordination, a commitment to agile and technology-neutral regulatory evolution, and ongoing vigilance against the potential for regulatory arbitrage.

In summation, Hong Kong’s new regulatory framework for OTC virtual asset trading represents a foundational achievement in its ambition to become a leading and responsible global virtual asset hub. While continuous effort and adaptability will be critical in addressing emerging challenges, this progressive framework provides a solid and credible foundation for the responsible growth and sustainable development of the virtual asset market in Hong Kong, enhancing trust, driving innovation, and reinforcing its esteemed position in the global financial landscape.

Many thanks to our sponsor Panxora who helped us prepare this research report.

References

• Financial Services and the Treasury Bureau. (2024, February 8). Government launches consultation on legislative proposals to regulate over-the-counter trading of virtual assets. Retrieved from https://www.info.gov.hk/gia/general/202402/08/P2024020800238.htm

• KPMG. (2024, March). Public Consultation on Legislative Proposals to Regulate Over-the-Counter Virtual Asset Trading. Retrieved from https://assets.kpmg.com/content/dam/kpmg/cn/pdf/en/2024/03/public-consultation-on-legislative-proposals-to-regulate-over-the-counter-trading-of-virtual-assets.pdf

• Securities and Futures Commission of Hong Kong. (2021, October 26). Statement on regulatory framework for virtual asset portfolios managers, fund distributors and trading platform operators. Retrieved from https://www.sfc.hk/en/News-and-announcements/Policy-statements-and-announcements/Statement-on-regulatory-framework-for-virtual-asset-portfolios-managers

• Financial Action Task Force (FATF). (2021, October). Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers. Retrieved from https://www.fatf-gafi.org/content/fatf-gafi/en/publications/Fatfrecommendations/Guidance-rba-virtual-assets-2021.html

• Hong Kong Monetary Authority (HKMA). (2022, October). Policy Statement on Crypto-assets and Stablecoins. Retrieved from https://www.hkma.gov.hk/media/eng/doc/key-information/press-release/2022/20221028e1a1.pdf